How to Limit Risks on Personal Guarantee Business Loans
Lenders always evaluate borrowers to predict whether or not they’ll repay.
Starting a small business is a risky proposition, and a small business start-up loan is the riskiest loan a bank can give. Even if you can get a Small Business Administration (“SBA”) loan guarantee, you will most likely still be required to sign a personal guarantee. The SBA says, “All owners of 20% or more of a business are asked to provide a personal guarantee in order to obtain an SBA guaranteed loan.”
For consumer loans, there are credit scores and numerous other sources of information to help with the decision. However, businesses – especially new businesses and operations that have never borrowed – probably don’t have a business-specific credit history.
With limited information it’s hard for lenders to make a decision. They would be more comfortable if they could see that you’ve borrowed money in the past and consistently repaid loans. When they can’t make a decision based on historical information, they require some sort of security (or they charge an extremely high interest rate). That security often comes in the form of a personal guarantee, although other approaches such as pledging business assets as collateral, can be used.
What is a Personal Guarantee on a Loan?
A personal guarantee is an unsecured written promise from a business owner and/or business executive guaranteeing payment on an equipment lease or loan, in the event the business does not pay. Since it is unsecured, a personal guarantee is not tied to a specific asset. However, in the event of non-payment a lender can go after the guarantor’s personal assets. By requiring personal guarantees, lenders hope to limit the risk their borrowers will default.
After all, if their homes and bank accounts are on the line, business owners presumably will do all they can to ensure their ventures succeed. This commitment is especially important for a new business, because a bank has limited means for evaluating its performance and likelihood of success.
How to Limit a Personal Guarantee
Although it can be difficult to entirely eliminate the need for a personal guarantee, you may be able to limit its scope by taking the following steps:
- Structure when the personal guarantee would go into effect. This could be based on the number of loan payments missed, the amount of working capital of the business, or the net worth of the business falling below a specified amount. Also, consider requesting business days vs. actual days to give yourself more time for reporting and the ability to respond to changing circumstances.
- Decrease personal guarantee with improved business performance. You can request the personal guarantee be reduced when business grows and the company becomes more stable. You can also ask that the amount guaranteed decrease as you make timely repayments.
- Limit a guarantee. Banks will always want an unconditional or unlimited guarantee. The business owner should start by requesting that the amount of the personal guarantee be limited either by the actual dollar amount or by a percent of the outstanding loan. If there are multiple owners, you can also seek to limit the amount of exposure by the percent ownership for each partner.
- Suggest terms of relief. You can ask to be relieved of the personal guarantee after a certain percent of the loan has been repaid or your share in business has been sold.
- Modify the reporting requirements. Lenders typically require guarantors to submit personal financial information at least annually. This is one of the ways for banks to locate and request personal assets. You can provide personal financial statements with the minimum acceptable disclosure.
- Avoid “joint and several” language if possible. Ask to limit who will guarantee the obligation. If there are multiple partners, try to avoid a joint and several personal guarantee. Push for an indemnification guarantee.
- Don’t cover more than 100 percent. Suggest that each partner carry a percentage of the guarantee rather than each partner carrying 100 percent – state laws may vary on the ability to do this.
- Try to eliminate certain assets. Request that certain assets, such as your personal residence or stock in the business, be outside the reach of the guarantee.
- Higher interest rate. Evaluate the option of paying a higher interest rate in exchange for no personal guarantee or limited guarantee.
- Do not include spouse as a guarantor. It is strongly suggested not to agree to a requirement of having the spouse as a co-signer on the personal guarantee. This provides both spouses with some protection, because personal assets under the spouse’s name will not be included, should the personal guarantee be called.
- Personal guarantee insurance. Personal guarantee insurance can protect your personal assets. With this coverage, you can limit personal risk to a more acceptable level.
Finally, you can try running the numbers again to determine whether you can borrow a lower amount and still have enough to operate, which should also reduce the amount of the guarantee.
While many lenders require a personal guarantee when making some business loans, it’s usually possible to negotiate at least some of the terms. Your legal and accounting professionals can help you understand the provisions of a personal guarantee and provide ideas for negotiating one that fits your needs. To discuss your specific situation, contact us today.
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