So many things in life come down to weighing risk versus reward. The general tendency is to choose the safest path, while remaining aware that risk is most certainly part of the journey at times. In fact, several recent studies centered on brain imaging have concluded that most of us are wired to be risk averse.
This brings us to the precariousness of personal guarantees within the small business lending realm. A personal guarantee is essentially a contracted promise between the business owner and lender surrendering the borrower’s assets to the former should the debt payments not be met.
There are several different types of personal guarantees within this framework, but the two most common are unlimited and limited guarantees.
Understanding What’s At Risk
An unlimited guarantee very plainly states that the owner of the business is responsible for paying back 100% of the loan amount, along with any associated fees. If the business owner defaults on the loan, the lender has the legal right to go after personal finances, such as life savings, college funds, and personal belongings, like a car or house.
With a limited guarantee, a dollar limit is set on exactly what can be collected from the borrower. This is typically an option the lender puts forth when the business is owned by multiple partners. The U.S. Small Business Association standards establish that anyone with a 20% or greater stake in the business should be part of the guarantee to pay back a business loan. Part of the limited guarantee is defining each business owner’s financial responsibility should the company default on the loan.
There is an important detail within a limited guarantee you need to be aware of, as there are two distinct types of limited guarantees—a several guarantee and a joint and several guarantee. With a several guarantee, each partner in the business has a predetermined percentage of liability, meaning they know from the outset the maximum amount they could owe, as there is a fixed percentage of the loan total attached to their name.
With a joint and several guarantee, each of the business partners is potentially liable for the full amount of the loan. The lender can essentially seek the full amount of the loan from any of the partners listed on the guarantee, thus if the business goes under and any number of the partners simply don’t have sufficient personal assets to cover their part of the loan, the lender can come after whomever does.
There may also be a provision written into a limited guarantee referred to as a ‘bad boy’ guarantee that protects the lender against borrower fraud and other unethical behavior. The bad boy clause allows the lender to legally convert a limited guarantee into an unlimited one.
The language within limited and unlimited guarantees can vary a bit from lender to lender, so be sure to go over the details carefully before signing.
"Perhaps the most important action you can take before jumping into any type of personal guarantee is a step back, to thoroughly access both your business and personal finances."
The Good, The Bad & The Ugly
The most important thing to keep in mind regarding a personal guarantee is what specific personal assets you set to assure the loan. Of course there will be several factors involved in this decision, such as the amount you’re seeking to borrow, the health of your business at the time of the loan and what the U.S. economic outlook is for the immediate future.
Prior to signing any kind of a personal guarantee, make sure you’re prepared to have the bank take over the assets you’re thinking about guaranteeing. Our guess is, when you were formulating your plan to start a business you undoubtedly knew there would be a level of financial risk involved. However, the notion of losing your house or risking your children’s college education was probably not on the table.
Perhaps the most important action you can take before jumping into any type of personal guarantee is a step back, to thoroughly access both your business and personal finances. Is your business running well enough to take the risks inherent in a personal guarantee, and can your personal finances handle the fallout in the event the business takes a wrong turn?
If you can objectively answer yes to these two questions and you’re truly comfortable with any and all of the provisions in the agreement then, and only then, can you go forward feeling confident that the risk is worth the reward.
Original Funding is here when you’re ready to have a more in-depth conversation about your lending options. Remember: A definite recipe for business disaster is when you borrow on hope alone. We’re looking forward to helping business owners and entrepreneurs who need short-term capital find the right small business loan product. Find out more here.