Every small business must contend with the challenges of financing their business operations. Whether you’re just starting up or expanding, business loans are often a critical part of a small business’s success. But what if you are required to personally guarantee the loan? Should you?
Read on to learn about how a personal guarantee works and the potential consequences of personally guaranteeing a small business loan.
What is a personal guarantee of a business loan?
Simply put, a personal guarantee of a business loan is a promise from the owner of the business that he or she will pay the loan if the business does not. Here are some pros and cons:
Pros:
- Often it is the only way a startup can obtain capital.
- Lenders will offer better loan terms if there is a personal guarantee.
- There is insurance available for personal guarantors to insure against default by the business.
Cons:
- If the personal guarantee is secured by personal assets, the business’s failure to repay and then your subsequent failure to repay puts those assets at risk.
- If the personal guarantee is unsecured and the business defaults, the lender can still sue you to collect if you fail to repay, and can garnish wages, levy on bank accounts, and file liens on real property.
A personal guarantee must be in writing and signed by the guarantor or the guarantor’s agent in order to be enforceable. It can be unsecured, meaning it is not secured to any one asset such as equipment or real property, or can be secured by property you own.
Be aware that any asset you pledge as security for a personal guarantee may be sold to satisfy the loan if the business defaults. Also, be aware that the guarantee document may provide that the guarantor is responsible for payment on the loan if the business defaults, as well as payment of interest, legal fees, and other fees.
If you are not an owner or on the executive team of the small business applying for a loan, use caution if requested to sign a personal guarantee. You may not be in a position to know the business’s full financial picture and whether repayment is likely to occur. It is always a good idea to consult an attorney when considering providing a personal guarantee of a business loan.
When do lenders require a personal guarantee?
A lender will often require a personal guarantee of a business loan as added assurance that the business owner intends to repay the loan regardless of the success of the business. It is common practice for lenders to require that entrepreneurs who own more than 20% of the business personally guarantee the loan; this is also the requirement for obtaining an SBA-guaranteed loan.
In small businesses owned by a single person or a family, business finances and personal finances are often intertwined, so it is logical for a lender to require personal guarantees of repayment. Often the spouse of a business owner will be required to offer a personal guarantee as well, for the same reasons.
Not every small business owner will be required to offer a personal guarantee. Where there is evidence of little risk to the lender, personal guarantees are not required. Here are some examples:
- Business revenue exceeds $25 million
- Business is registered on a public stock exchange
- Business is a non-profit;
- Business is venture-backed;
- Business is structured as an Employee Stock Ownership Plan (ESOP).
What happens if the business defaults on the loan?
If the business defaults on the loan—which can happen for any reason ,but most likely from insufficient revenue, liquidation under a Chapter 7 bankruptcy filing, or reorganization under Chapter 11 bankruptcy—the personal guarantor remains personally liable for that debt.
What can you do about it? It depends on how your business was organized. If you are a sole proprietor or LLC, in many cases the debt will be discharged as to you and as to the business if you file a Chapter 7 bankruptcy petition. However, if your business is a corporation and the corporation files Chapter 7 bankruptcy, you will remain liable for repayment of that debt. Keep in mind that businesses that file Chapter 7 bankruptcy do not continue business operations, and all business assets are liquidated for the benefit of the business’s creditors.
If the business files a Chapter 11 bankruptcy, the business will have a plan of reorganization. If that plan includes only partial payment of the debt that an owner personally guaranteed, the guarantor remains liable for repayment of the remainder.
If the debt was secured by your personal assets, in most cases the lender is empowered to seize and sell those assets if they file a collection lawsuit and obtain judgment against you. If the assets sell for less than the amount of debt you guaranteed, the lender could also pursue collection of the account deficiency by levying on bank accounts, garnishing wages, or filing a lien against your real property.
When a business defaults on a loan, the business’s credit is negatively affected. If a personal guarantor then defaults, then the guarantor’s credit will also suffer. The impact on credit could last for up to 10 years.
In most states there is a four-year or six-year statute of limitations on collections pursuant to a personal guarantee of a business loan.
What happens if you want to sell the business?
If you want to sell your interest in the business and a loan that you personally guaranteed is outstanding, be sure to obtain a release from liability. If you do not and the new owner(s) default on the loan, you could remain personally liable for that debt even though you no longer own interest in the business. Sometimes lenders will require that you pay off the loan if you sell the business.
Be sure the review the loan documents and speak with your lender if you have questions about this, prior to taking any action to sell your interest in the business.
