2 Different Types of Personal Guarantees Your Business Needs to Understand
We'll break down the two types of personal guarantees you may be asked to sign during the loan process, and what each means for your business.
If you’re looking to grow your small business, chances are you might find yourself in the market for a small business loan. After all, working capital influx could be just what you need to reach the goals you’ve set. As you approach the loan process, you’ll find many lenders will require you to sign a personal guarantee. So, after you’ve been approved for any loan, you may be eager to sign the agreement, get that cash in hand, and get going. But wait! You’ve got to be cautious of what you’re agreeing to here. If the loan requires you to sign a personal guarantee, what does this mean for you down the road?
Prior to the late 1980’s, most banks didn’t require any type of personal guarantees. This meant that if a business failed, the owner was not liable for repaying what they owed to the lender. As a result, the banks were the ones who suffered the loss. Since then, bank regulators have created a rule that all banks must have anyone who owns 20 percent or more of a company sign a limited or unlimited personal guarantee.
If you’re ready to sign a loan and you see there is a personal guarantee, you need to understand what type of personal guarantee it is, and what it implies for both you and your business. Let’s explore how these personal guarantees work and how they’ll affect you in the unfortunate circumstance that you will be unable to make your business loan payments.
1. Unlimited Personal Guarantees
If you sign an unlimited personal guarantee, you are agreeing under contractual terms that, in the instance that you are unable to make your monthly payments and default on your loan agreement, you are still responsible for repaying 100 percent of the loan amount owed. If your lender needs to seek a lawyer in order to obtain what’s owed to them, you will also be held responsible for covering the cost of any legal fees. For example, if you owe $10,000 in loan payments and the lender’s legal fees cost $5,000, you would then be responsible for paying back a total amount of $15,000.
In the unfortunate circumstances that you do default on your loan, you stand to lose any asset that will help cover the cost of the loan, even if these particular assets don’t directly correlate with your company: your house, your car, your retirement fund and anything else of value. If you are married, even your spouse’s assets could be up for grabs!
The unlimited personal guarantee is by far the more dangerous type, as it offers you as the borrower no financial protection in the event that your business goes south. Before you sign your life away with a personal guarantee, it’s critical that you are absolutely confident in your ability to repay your business loan in full. We cannot stress this enough!
2. Limited Personal Guarantees
If you and multiples business partners choose to take out a loan, you will likely be asked to sign a limited personal guarantee. A limited personal guarantee basically means that if you default on your loan, you share the burden of repayment amongst any shareholder that has a 20 percent stake, or more, in your company. There are, however, two different types of limited guarantees: a several guarantee, and a joint and several guarantee. Make sure you are aware of which guarantee you are agreeing to as they each mean different things.
A several guarantee means that each shareholder has been given a set amount of percentage liability, so in a worst case scenario situation, each person will already know what they’re responsible to repay the lender. The percentage each party will be required to pay is usually proportionate to their stake in the company.
A joint and several guarantee, however, means that each person who signs on the dotted line could potentially be held responsible for the entire debt owed. So if one of your partners disappears or doesn’t have enough personal assets to cover their piece of the pie, the lender could come after you to cover the unpaid portion of those who didn’t or couldn’t cover their share.
Lastly, you also need to be aware of a “bad boy” guarantee. A bad boy guarantee could be written into a limited personal guarantee, which will allow it to be converted into an unlimited guarantee. This agreement is intended to protect the lender should you commit fraud, among other things. It allows the lender to take the legal action needed to obtain what they’re owed without having to worry about the cost of legal fees.
Personal guarantees aren’t meant to be confusing but due their technical nature, they unfortunately are. If you do not understand the terms of your guarantee, be sure to reach out to a lawyer for clarification. It is pertinent you do not sign anything until you know exactly what you’re dealing with.
Remember-there is a very real possibility that, although you don’t plan on it, you may default on your loan. Beyond understanding the personal guarantee, also take an objective look at both your business and your finances because if you do, unfortunately, default on your loan, you stand to lose a lot.
If you want to take precautions, be sure to ask for an amortization schedule before signing. This will break down your loan payments, so you have an idea of how this will affect your cash flow.
Getting a small business loan is a serious decision for not only your business, but your personal life too. Personal guarantees are only a portion of the things you need to thoughtfully consider before signing the dotted line. Do your research, consult with your accountant, and make sure before committing to anything, that this loan is truly what is best for your business.
Meredith Wood is the Editor-in-Chief and VP of Marketing at Fundera, a marketplace for small business financial solutions. Specializing in financial advice for small business owners, Meredith is a current and past contributor to Yahoo!, Amex OPEN Forum, Fox Business, SCORE, AllBusiness and more.