Many small business owners find that banks and creditors often ask them for a personal guarantee. While a guarantee can bolster your chances of getting approved for the loan, is it truly a wise decision?
In this article, we’ll cover all things about personal guarantees and what effects they might have on your business in the long-term. Covering both the good and the bad, we’ll go over the details of personally guaranteed loans, what benefits they offer, and what risks they might pose.
Personal Guarantees 101
Let’s address your first question: what is a personal guarantee?
Although the definition of a personal guarantee will vary depending on who you ask, you can think of a personal guarantee as an individual’s promise to repay credit borrowed by a business for which they are a part of. Therefore, if the business is unable to make payments on the debt, the individual who signed the personal guarantee is on the hook.
Understandably, personal loan guarantees improve your chances of getting approved for a loan. When you personally assume liability for the debt, rather than your business alone, the lender has an extra degree of assurance regarding your ability to pay it back.
In other words, signing a personal guarantee makes you more trustworthy in the eyes of a lender. Just in case your business cannot make good on its pledge to repay the debts incurred by the loan, your guarantee provides a safety net for the bank to fall back on.
Personal Guarantees and Limited Liability
Some corporations have limited liability protection embedded in their terms of incorporation. However, signing a personal guarantee as part of a limited liability company strips away some of the legal protection that limited liability companies provide.
Under a limited liability arrangement, corporate debts and liabilities are not shared or assumed by the individual members of the company. On the other hand, this clause is negated for that individual who signs a personal guarantee loan. In this case, they take on personal responsibility for the debt. Limited liability companies include:
- Limited liability company (LLC)
- Limited liability partnership (LLP)
Unlimited Personal Guarantees
There are several kinds of personal guarantee loan types. An unlimited guarantee stipulates that the lender is obliged to recover the entirety of the loan amount. Usually, this sum also includes legal fees and other associated charges added on top.
In the event of business failure or outright default, you or your business might be threatened with legal action to take assets from you to repay the loan. This can include everything from your personal savings to your house, vehicles, or retirement fund, not to mention legal fees and interest on top.
To illustrate the severity of an unlimited guaranteed loan, imagine a scenario in which your business borrows $100,000 from a loan that you signed. Your business pays down $20,000 but fails to make any installments after. The creditor spends $10,000 on lawyer fees to gain judgment in their favor. Therefore, you would personally be liable to repay $90,000.
Limited Personal Guarantees
Unlike an unlimited guarantee, and limited guarantee loan limits the amount of money that can be collected from the individual guarantor. According to the standards set forth by the US Small Business Administration (SBA), anyone with a stake of 20 percent or more in the company need to take part in the personal guarantee loan agreement.
The two varieties of limited personal guarantee loans are described at length below. These loan types have unique benefits and drawbacks that vary according to the terms agreed upon.
Under a joint personal guarantee loan agreement, everyone party to the guaranteeing process must be potentially liable for the total incurred debt. Although the lender can recover only up to the limited amount, they can collect debt repayments from any of the co-signers on the agreement.
Under this scenario, it is plausible that you might be on the hook for the liabilities agreed upon by your business partner if they agreed to the loan but did not have enough assets to cover repayments. Before agreeing on a joint guarantee loan, ensure that you trust the word of everyone involved.
A several guarantee holds that each signatory on the agreement is held to a fixed share of the total liabilities incurred by the business. If two business partners agree to share an even split of the liability, then each would owe 50 percent of the loan if the business defaults or misses a payment.
Protecting Yourself Against Borrower Fraud
Unfortunately, the distinction between unlimited and limited personal guarantee loans are not so clear-cut. Although it’s an inherently deceptive tactic, some bad faith lenders will include hidden provisions in the agreement that effectively convert a limited guarantee into an unlimited one.
Every prospective borrower must be on alert when negotiating terms for a personally guaranteed loan. Sadly, sneaky clauses and hidden provisions can be very vague and included completely unbeknownst to the borrower. To protect yourself, it may offer you some peace of mind to consult with an attorney or legal professional before signing the agreement.
If you default on a personally guaranteed loan, you might be responsible for providing more than only cash or liquid assets. For example, if you own a trucking and logistics company with an inventory of 100 trucks and you default on a personally guaranteed loan, then you are responsible for helping the creditors sell the trucks and other vehicle assets as a form of repayment.
Thankfully, specially-qualified lawyers can weed out predatory loan clauses. This is a sound investment if you want to spare yourself the trouble of auctioning off your business’s last assets after you’ve been forced to dissolve the company. In short, stop a bad situation from being made worse by having your guarantee business loan looked over by a lawyer.
What’s the Risk?
There is no shortage of risks when it comes to signing a personal guarantee on business loans. Once you have personally guaranteed the loan, you have granted the bank or lender permission to claim or garnish your wages or assets to make up the cost of the loan.
Many borrowers assume that repayments can be made on the borrower’s terms. However, the real experience often doesn’t reflect this assumption. Instead, virtually all the individual’s guarantor’s personal property can be reclaimed and taken from them by a repossession company. If you’ve guaranteed a business loan, any of your property (or your family’s) can be taken at the creditor’s will.
If the lender decides to pursue legal action against you or your business, then your credit history can be permanently affected for the worse. After your business defaults on a guaranteed loan, it is common for borrowers to be given a court order to repay the loan amount.
Consequently, credit ratings take a hit which can hinder your chances of getting approved for a loan, finding a house or job, or securing other forms of business credit. Unfortunately, all assets in yours or your spouse’s name are up for grabs if you default. Therefore, making repayments on a guaranteed loan is important if you don’t want to cause serious stress in your family’s life.
Luckily, you have means at your disposal to protect you from exploitation from creditors and lenders that include “bad boy guarantees”. Whenever possible, we advise taking every precaution available to you to ensure that the loan terms you agree to are fair and equitable.
First, you must be willing to negotiate the terms of the loan or at least hire a representative to do it for you. Usually, when you meet with lenders, they will provide you with a standard loan agreement. This is not necessarily the final version of the agreement. You can suggest adding new clauses or terms as you see fit to better protect you against exploitation.
Make sure that there are no hidden terms or questionable passages of text contained in the agreement (i.e., nothing vague or overly complex). Instead, everything should be clearly stated in terms that lay people can easily understand. If it’s important to you, demand that your family’s or spouse’s assets be kept off the table during the negotiation sessions.
The Bottom Line
Signing a personal guarantee is risky business. Although it might help you gain approval for a much-needed loan, it should be considered an option of last resort. Once your business has established a good credit history, you should distance yourself from personal guarantees. Instead, provide collateral on secured loans in the form of cash or tangible business assets.