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As you go through the process of applying for a business loan, you’re likely full of optimism, with your eyes fixed squarely on the prize ahead as you move your business dreams forward.
Then, you see that one extra section of the application. It talks about a personal guarantee. You might hesitate for a moment, or, in your relentless enthusiasm, you might not even think twice.
But wait, what exactly are you signing here?
Of course, no one applies for a business loan with the intention or even suspicion that they may not be able to pay back the debt. But the reality is that not all businesses succeed. You can’t predict what may happen in the future.
If you sign a personal guarantee without understanding the terms, you could be risking your and your family’s financial future in ways you never even imagined. Optimism is certainly essential to the entrepreneurial spirit, but you should always be prepared in case you find yourself in a tough situation.
So before you sign that dotted line, let’s take a look at the most common types of personal guarantees you might encounter in your business loan agreement.
When you sign an unlimited personal guarantee, you are agreeing to allow the lender to recover 100 percent 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 judgement 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 percent 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 guarantees aren’t always cut and dry. 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.
Say, for example, you own a sunglasses store, and the store goes out of business. After seizing the store and all the sunglasses inventory inside, your lender can then require you to help them convert that inventory they just seized into cash. Because your lender doesn’t have the same industry network that you do, 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 first 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, right? A licensed attorney will be able to spot clauses like these and explain what they mean before you agree to anything. Your attorney may even be able to red-line certain clauses in the contract and negotiate with the lender for more amicable guarantee terms.
Before you agree to any sort of 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.