Personal Guarantees: Fact or Fiction
Is a personal guarantee the cherry on a lender’s sundae, or an essential part of the business credit deal?
A personal guarantee is when a business owner that has a business credit line agrees to personally be responsible to pay for the loan in the event that the business defaults.
Lenders generally require anyone who owns more than 20% of a company to personally guarantee a loan. This is a typical requirement for all closely held and non-public companies. The lenders also usually require personal financial statements and tax returns. This is their standard request, but really, it’s an opening line in an ongoing negotiation with the lender that doesn’t end until the loan papers are signed.
Most lenders require personal guarantees that have joint and several liability, meaning that each individual owner who signs a guarantee can be held responsible for the entire amount of the loan. So even if you only own 20% of the company, in the “best” personal guarantee for the bank, you own 100% of the loan.
Whether the banks should require a personal guarantee, and the borrowers should sign one, is a hotly debated topic.
Here’s the lender’s perspective:
“You want us to partner with your company and back you financially by giving you this loan, and you won’t partner with it yourself by giving us your personal guarantee? Personal responsibility shows us you have a commitment to making the business work. Without it you could easily walk away or not try very hard.”
Here’s the business owner’s viewpoint:
“I’ve already put my last penny of savings into this business, and you’ve tied down all of my business assets and future income streams with this loan, that’s enough. If the business doesn’t make it, I don’t want my credit ruined forever too.”
There are lenders that make business loans without personal guarantees, but they are rare. Following are four distinct ways you can eliminate the need for personal guarantees.
They are:
1. start building corporate credit now, even if you don’t need it.
When you are beginning the corporate credit building process, while your business is young you will always be asked to personally guarantee the debt. That way, your business builds a credit history using your personal guarantee when the credit lines are small and new, limiting your personal risk. This way when your business is older, you are more likely to get larger lines without the guarantee.
2. Negotiate away the personal guarantee.
There are two types of personal guarantees: Unlimited (where the borrower is responsible for the entire loan, principle, interest and any costs and fees) and Limited. A limited guarantee can be limited in a number of ways, since as amount, time duration, or certain performance benchmarks such as revenue or principle paydown.
So a great way to limit your exposure to a personal guarantee is to negotiate a limitation with the lender. For example, offer a personal guarantee for the first two years (when the business credit is getting built up and stabilized), or have a guarantee that is removed after so many early loan payments, or when the principle is paid down a set amount.
Consider several other factors that may be offered in place of a personal guarantee, such as a higher rate of interest or points, a smaller loan amount of loan period, or the maintenance of a compensating deposit balance for the loan. The goal is to secure the loan with assets and income, and not your personal credit score.
3. Get referrals for lenders that don’t require personal guarantees.
Staples, FedEx and Dell computers are all companies that don’t require personal guarantees. In fact, on the Staples credit application where it asks for the Taxpayer ID it states:
“NOTE: Required by USA Patriot Act. Social Security # may be provided if you are a sole proprietor and do not have a business Tax ID Number.”
4. Write your own loan terms.
90% of all businesses are financed by non-traditional means. This means private money, not institutional lending, is responsible for the growth of most businesses. When you borrow from private citizens, personal guarantees are rarely required. For these types of loans, you write your own terms. Private money has the additional benefit of being “phantom debt” and not showing up on your credit report, making access to institutional loans more likely.
For ways to find private lenders, be sure to join us on May 31st and June 1st for the Credit Millionaire Marathon where I’ll be doing an entire session with Paulie on this very topic.
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