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A personal guarantee is, essentially, a legal promise by the individual business owner or owners that they will repay any outstanding business debt if the business fails to do so.
If you’re applying for a small business loan, you’re likely full of optimism—as you should be! Trying to secure financing without being positive about how the money could help your business is a recipe for disaster, especially if you’re loan application includes a personal guarantee.
A personal guarantee is a legal clause designed to protect the lender in a situation where the business is unable to pay back its debt. If you sign a personal guarantee, you could be putting your and your family’s financial future at risk. So before you sign that dotted line, let’s learn some more about what personal guarantees are, and take a look at the most common types of guarantees you might encounter in your business loan agreement.
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No one applies for a business loan with the intention that they may not be able to pay back the debt. But the reality is that not all businesses succeed and, therefore, not all debt is paid back. Lenders know this, which is why they created personal guarantees.
A personal guarantee is a legal promise made by an individual— the personal guarantor—to repay credit issued to their business using their own personal assets in the event that the business is unable to repay the debt. Business loans with personal guarantees attached are typically unsecured loans because they are not collateralized through your business’s assets.
A personal guarantee is usually signed during the loan application or approval process. Small business owners often use a personal guarantee since they are invested in the success of their business.
Under a personal guarantee, a creditor has legal claim to the personal assets of the guarantor. This can include checking accounts, savings accounts, cars, real estate, and other liquid assets. A small business owner seeking to provide a guarantee for credit will typically need to provide their own credit history and financial background, along with their business’s credit information.
The benefit of a personal guarantee is that if you have a lot of personal assets, it mitigates the risk of the lender, which can lead to more credit and better terms. Well-established businesses with a long credit history may be able to acquire financing without a guarantee.
Now that we are familiar with what a personal guarantee is, let’s take a look at the two different types of personal guarantees: unlimited and limited.
When you sign an unlimited personal guarantee, you are agreeing to allow the lender to recover 100% of the loan amount in question, plus any legal fees associated with the loan.
If your business fails or you default on your loan for any reason, your lender can hire lawyers to gain a judgment in their favor, then go after your life savings, your retirement, your kid’s college fund, your house, your car, and any other assets they can find to cover the the full cost of the loan, plus interest and legal fees.
For example, if you still owe $50,000 and default on the loan, and your lender spends $5,000 in legal fees to gain a judgment in their favor, you will then owe $55,000, which can be legally taken from any part of your finances in order to make good on the loan.
These guarantees are called unlimited for a reason. They offer you as the borrower basically zero financial protection if your business isn’t as successful as you planned.
As the name suggests, limited personal guarantees set a dollar limit on what can be collected from you as the borrower in the event that you default on your loan.
Limited guarantees are often used when multiple business partners take out a loan for the company together. SBA standards state that anyone with a 20% or greater stake in the business should be part of the guaranteeing process. These guarantees help define each person’s piece of the debt pie should the company default on a business loan.
Limited guarantees are not without their own hangups, however. Before you agree with your business partners to sign a limited guarantee, check whether you’re signing a several guarantee or a joint and several guarantee.
With a several guarantee, each party has a predetermined percentage of liability. You’ll know from the beginning the maximum you might owe in a worst-case scenario, which will be a fixed percentage of the loan—usually proportionate to your stake in the company.
A joint and several guarantee, however, differs in that each party is potentially liable for the full amount of debt. The lender can’t recover more than it is owed, but it can seek up to the full amount from any of the parties listed on the guarantee. So if your business fails and then your business partner disappears or doesn’t have sufficient personal assets to cover his or her portion of the loan, your lender can come after you for both your stake in the guarantee, plus whatever portion remains unpaid from your partners.
The lines between limited and unlimited personal guarantees aren’t always cut-and-dried. Before signing a personal guarantee, be sure to review the language closely and look out for gray areas.
In an effort to protect against borrower fraud and other “bad” acts, there may be a provision (often referred to as a “bad boy” guarantee) written into a limited guarantee that allows it to be converted into an unlimited one. This is designed to ensure that borrowers behave ethically and legally by, among other things, allowing a lender to seek justice against a fraudulent borrower without having to worry about the legal cost to do so.
Personal guarantees, even supposedly limited guarantees, are often intentionally vague and can include provisions and requirements from you as the borrower that you would never even dream of. Due to provisions like these, it’s important to read between the lines as best you can before signing a personal guarantee.
If legal language isn’t your forte, it’s worth every penny to hire a professional who can explain in detail the full ramifications of the guarantee before you sign. If you don’t, you could be on the hook for a lot more than you bargained for.
For example, say you own a sunglasses store, and the store goes out of business. If you signed a personal guarantee, your lender could seize the store and all the sunglasses inventory inside, then require you to help them convert that inventory they just seized into cash. Depending on the terms of your personal guarantee, you may be expected to spend a pre-determined amount of time helping sell the remaining sunglasses to your contacts (competitors, wholesalers, etc.) in order to convert those assets into cash on their behalf.
After losing your business, the last thing you want to do is spend your time selling off the leftovers to the highest bidder without keeping a dime to show for it. A licensed attorney will be able to spot clauses like these and explain what they mean before you agree to anything. Your business attorney may even be able to red-line certain clauses in the contract and negotiate with the lender for more amicable guarantee terms.
A personal guarantee is just one way a lender can protect their investment. If you don’t want to risk your personal assets, try to get a loan that is secured in one of the following ways:
A blanket business lien is like a personal guarantee for your business’s assets. It is a common legal claim included in the fine print of almost all small business loans. When lenders file liens for unpaid debts, they can sell a business’s assets in order to collect the money owed to them.
If a lender files a blanket lien, they can essentially bankrupt your business in pursuit of repayment for the principal and interest on your loan. Note that most loans that contain blanket business liens also require personal guarantees. This way, if your business’s personal assets aren’t enough to repay the debt, the lender can then dig into your personal assets.
If you have collateral to put up, you may be able to secure a collateralized loan. Collateral is a specific asset or set of assets that gets liened against a small business loan. If a business fails to make regular payments on the loan, lenders can obtain a court order to seize that property from the borrower and liquidate it for repayment of the loan.
Collateralized loans are considered secured loans, as opposed to loans with personal guarantees or blanket business liens, which are considered unsecured. Generally speaking, it’s better to put up collateral for a loan if you can than put all your personal and business assets at risk with a personal guarantee or lien.
Before you agree to any sort of personal guarantee, you have to look at your business and your finances objectively, understanding the real possibility that despite your best efforts and intentions, there is a chance your business could fail. Think through all the possible ways each provision within the agreement could affect your business and your personal finances down the line. In the end, you must ask yourself if the risk is worth the reward.