The Different Types of Personal Guarantees for Your Business
The American dream is alive and well, and the possibility of owning your own business is a dream that can become your reality.
However, it usually costs money, sometimes a lot of money depending on the type of business you’re starting. Finding the funds to get your business off the ground can be one of your first hurdles.
The good news is that if you have a solid business plan, good personal credit history with minimal debt and some money of your own to invest in the business, you could qualify for small business financing.
Traditional lenders, such as banks and credit unions, and alternative lenders, mostly non-bank companies, offer funding solutions for new and established small businesses.
As you start the process of applying for a small business loan, don’t be surprised if the lender asks for a personal guarantee to secure the loan.
Here’s what you need to know about personal guarantees and the different types of personal guarantees you might come across.
What is a personal guarantee?
Getting approved for a business loan can be difficult, especially for a startup or a business with no credit history. Almost all lenders require a personal guarantee. Without it, many small businesses can’t qualify for a loan or line of credit.
So, what is a personal guarantee and why do lenders require you to sign one?
A personal guarantee is part of the loan agreement between the lender and borrower. It is a legally binding and enforceable agreement stating that the guarantor – the business owner — is personally liable to pay back the outstanding debt if the business defaults on the loan.
By signing a personal guarantee, you’re putting yourself and your financial security on the line.
The harsh reality is that many businesses fail. Lenders want the peace of mind knowing that they are able to recoup the debt if the business cannot pay back the loan.
Types of personal guarantees
Here we break down the three common types of personal guarantees: Unlimited guarantee, limited guarantee and “bad boy” guarantee.
The Small Business Administration requires that “individuals who own 20% or more of a small business applicant must provide an unlimited personal guarantee.” Many lenders followed suit requiring personal guarantees for all types of business loans or unsecured lines of credit.
An unlimited guarantee means that you are solely responsible for paying back 100 percent of the outstanding loan amount, plus any associated fees. On top of it, your personal credit can take a hit if the business is unable to pay back the loans in a timely manner or if the business defaults on the loan.
Just because you might not have the cash sitting in the bank doesn’t mean you’re off the hook. Lenders can go after your personal assets to recoup their losses. This could be assets such as an individual retirement account, your child’s college savings account or your home, to name a few.
If the lender has to hire an attorney to get their money back, you’ll be on the hook for those legal costs as well.
A limited guarantee is written into a loan agreement when there are multiple business owners. The liability is divided across multiple business owners or partners.
As the name suggests, each guarantor has a limited amount of money or percentage of the outstanding debt that they will owe if business defaults on the loan.
There are two types of limited personal guarantees — a several guarantee and a joint and several guarantee.
A several guarantee means that multiple individuals are personally held responsible for a predetermined portion of the debt in case the business defaults on the loan. Each guarantor is only held responsible for their portion of an obligation under the loan agreement. For example, if two partners equally own a pizzeria, each partner is personally liable for 50 percent of any remaining unpaid debt if the business cannot pay back the loan.
A joint and several guarantee is a several guarantee, meaning each partner has a predetermined percentage of liability, but with the potential of taking full personal responsibility if a partner does not pay their portion of the debt.
If you agree to go into business with a partner or multiple partners, you should consult with an experienced attorney. You don’t want to put your financial security at risk if the loan goes into default and a partner is no longer able to pay their portion of the outstanding debt.
The ‘Bad Boy’ guarantee
A ‘bad boy’ guarantee is a provision written into limited personal guarantees that gives the lender the right to convert a limited guarantee to an unlimited guarantee if the borrower commits certain erroneous acts. By signing a bad boy guarantee, a guarantor promises not to violate specific conditions, such as committing arson or fraud, that are detailed in the loan agreement.
This guarantee is meant to discourage ‘bad’ acts by the guarantor(s) that could put the lender at risk of not getting their money back. For example, if a business failed and the guarantor intentionally filed bankruptcy to avoid paying back the outstanding business loan, that would trigger the ‘bad boy’ guarantee on the loan.
A triggering event the term used to describe an act or event by the guarantor that can harm the lender’s ability to recoup outstanding debt, such as:
- Failure to pay expenses that can create liens on the business
- First full loan payment is not paid on time
- Failure to pay taxes
- Bankruptcy by one of the guarantors
Bad boy guarantees give the lender extra protection. The specifics of the types of trigger events are detailed in the loan agreement.
Many business owners choose to incorporate their business. By setting up a limited liability company (LLC) or S corporation, owners are personally protected from business debts or lawsuits. For example, if a customer slips and falls in your restaurant, you cannot personally be held liable if they decide to sue.
However, operating under an LLC or corporation does not protect you from any money that you have personally invested in the business, or any loans or business lines of credit that you have personally guaranteed.
The bottom line
Lenders look at the financial health of the business owner as an indication of how they will operate the business. By signing a personal guarantee, the business owner has their own skin in the game and in theory, makes the best decisions for the business in order to avoid putting their own financial security at risk.
Before you sign on the dotted line, make sure you understand exactly what is at stake for your financial future. An experienced attorney can help you comb through the fine print and might even be able to negotiate some of the terms of the loan.