Almost all businesses, small, medium, or big, are looking to expand in one way or another. For well established companies, this can be much easier on account of the high cash flow and large capital reserves they possess, which factors greatly into fueling expansion. However, unfortunately, this is not usually the case for small businesses who are struggling to create a niche for themselves in the market. Expansion can be challenging for them, and it almost always requires a loan of some kind.
One aspect of acquiring a loan as a small business can be the lack of business history or creditworthiness that has been established. As a result, banks and other financing institutions usually require some form of guarantee from the business owner or owners to lessen the risk when making a loan. In most cases, this guarantee will come in the form of a personal guarantee.
What is a Personal Guarantee?
A personal guarantee is a promise that a business owner makes before he collects a loan, saying that he is liable to pay back the loan should the business fail to do so. Lenders require such promises as a form of safety net, especially in light of the high failure rate for new businesses. In fact, according to the Bureau of Labor Statistics, roughly 50% of small businesses fail within the first four years of operation.
There are many different types of personal guarantees, all of which have different levels of risk for the business owner, so it is important that you carefully consider any personal guarantee you may sign.
1. Read the Fine Print
With the different types of personal loan guarantees available, it is important that you are very careful and thorough in your reading of the contract. The prospect of the loan is exciting, but as in anything, it is important that you don’t get carried away.
Some personal guarantees are unlimited, meaning that the business owner is liable to pay all of the money that was loaned to his business, including any legal fees that may have been incurred in the process of collecting. This unlimited liability is usually a problem only where the business owner defaults and has to involve lawyers in recovering the defaulted funds.
Limited personal guarantees on the other hand are less broad and stipulate a fixed amount of money to be paid in the event of a business failure. Usually, the business will be responsible for covering the cost of the loan, and in event of business failure the owner with a personal guarantee will then take up the responsibility of paying back the loan.
The line between unlimited and limited personal guarantees however isn’t always so clear-cut, so make sure you talk to your case manager about what your liability could be.
2. Get a Lawyer
Legal language can be thick, dense, and hard to understand, especially if you haven’t got a lot of time. In light of this, we cannot stress enough the importance of working with a qualified lawyer to look over any and all contracts before you sign on the dotted line. Additionally, a good lawyer may also be able to help you work with the institution you are working with. They’ll be the ones best suited for advising you on the legal risks and liabilities you’ll incur through the signing of a personal guarantee. In a study completed by Credit Donkey, they found that around 12% of people aged 18 to 44 sign contracts without reading them, while an average of 64% of all people simply skim through them.
3. Look for an Alternative
A loan with a personal guarantee always has some kind of risk, and small business owners should understand that accordingly. Many small business owners lack the personal funds to be able to pay back a loan in the event that their business fails to pay it back. Therefore, it is advisable for you to explore all your options before signing a personal guarantee form to receive a loan. Talk to your financing provider about what options are available, including what terms and rates you could receive. If you’re not comfortable with having a personal guarantee, you can usually speak to someone at the lending company who will help you understand all of your options fully. You might discover that you have another option you didn’t even think about!
4. Determine Acceptable Risks
There are some aspects of a loan agreement that are negotiable, so when you go in to meet with the loan provider make sure you know what risks you believe are acceptable for your financial situation. To prepare for this, you should calculate your assets and then determine from there what you are comfortable putting on the line. Remember, building a small business almost always involves risks. But don’t be too much of a risk taker that you end up hurting your chances of success.
5. Specify the Assets that Can Be Taken
In the event that your company fails after taking out a loan for any reason, the personal guarantee in some cases can enable lenders to demand any assets you may have to pay back the debt. In anticipation of this, with the help of your lawyer, you should make it clear what assets are immediately available should you default on the loan. Knowing what assets you could use in the event you need to pay back a defaulted loan is a best practice whenever you look for financing. Some states, like Florida and Texas, have laws stating that your home cannot be seized by banks, however, many other states do not have laws like these on the books. Another important distinction to make is if you co-own any assets with someone else. That way the implications will not impact individuals besides yourself. As always, it’s better to take preventative measures rather than being reactionary.
6. Demand Clarity
The nature of legal documents is that they are wordy and confusing. This almost always benefits lenders as opposed to borrowers. It is important that you and your lawyer work through ambiguous areas in the loan documents so you know what you’re agreeing to, both in terms of personal guarantees and other terms of the loan. Some financing isn’t structured as a loan, and this also changes the way that your personal guarantee will apply. Pay attention and ask your funding provider for clarification on any points where you’re not 100% confident.
Building Your Business for the Future
Taking out a loan to help strengthen, grow, or shore up your business can be a great idea. However, as with everything, taking out a loan involves some kind of give and take as well as a certain level of risk. By considering the six points above and mitigating your risks, you can make sure that you put your business in a position to succeed without risking everything.