If your business is short on cash, a new loan can look like the way through. The guarantee may seem like a formality - just a paper you’re “supposed” to sign. Running out of money and time, you just sign to keep the loan rolling. That is a mistake. Lenders often request a personal guarantee as a means of mitigating risk. In some instances, it can be difficult or impossible to secure funding without a personal guarantee. A personal guarantee is an agreement you make with a lender to take on personal liability for a company’s debt. Even if the loan is in the company’s name, the personal guarantee makes it your personal obligation to repay the debt if the business fails to pay. As a result, the lender may pursue the personal assets of the business owner to satisfy the outstanding debt.
The need for a personal guarantee usually arises when a lender has concerns about the company’s ability to repay the loan. Additionally, a lender may require a personal guarantee to ensure that the business owner has a vested interest in the success of the business. Depending on the specific terms of the guarantee, the lender may be able to pursue the business owner directly before attempting to collect from the business.
Before deciding anything, start with the most basic question: do you need that loan? If not, don’t sign. If you do, don’t sign any personal guarantee without understanding how much you will owe if things go wrong. Three things matter most: whether the guarantee is limited or unlimited, whether it waives your defenses, and whether you can revoke it.
The first is that there are two kinds of personal guarantee. With an unlimited guarantee there is no cap: you are responsible for the total loan amount if the business fails to pay, including the lender’s legal fees. If the bank wants to recover the full cost of an outstanding loan, your entire personal asset portfolio is fair game. With a limited personal guarantee, the liabilities are capped. There may still be significant financial trouble, but not necessarily complete ruin. You need to know the risk you are taking with an unlimited guarantee. If it isn’t clear from the text of the guarantee, ask your lender to explain the consequences to you. Where you can, negotiate for a limited guarantee with a specific dollar cap. If you own only part of the business, push to limit your guarantee to a percentage of the debt that matches your ownership stake. Take a close look at the wording of the guarantee and compare the guaranteed amount to the business’s total loan balance.
Here is why that matters. Say you own 10% of a business and sign a personal guarantee so the company can borrow $500,000. If the guarantee is unlimited, the lender can go after you for the entire $500,000. That is true even if other owners signed guarantees too, because the lender can choose to collect the full amount from a single guarantor. A limited guarantee on a pro rata basis means that the lender can only come after you for up to $50,000. You won’t owe the whole $500,000 just because your signature is on the paper. Consider how important the loan is and what your other options are.
Some lenders also ask for a spousal guarantee. As defined under the Equal Credit Opportunity Act, that kind of guarantee may be prohibited in certain circumstances, so don’t assume the request is proper just because it is in the paperwork. Either way, be sure you know what you’re giving away by signing.
The second thing is the waiver. Most personal guarantees, limited or unlimited, include a clause in which you waive any and all defenses except payment in full. In legal terms, the “defenses” here are any and all arguments you might have for not paying the guarantee. If you waive “all defenses except payment in full,” you’re not going to have any excuses if the loan defaults and the lender turns its guns on you. No other defense, no matter how strong it is, can be used against the lender. The bank can get away with a lot if you waive all your defenses. Suppose bank officers made fraudulent misrepresentations to get you to sign. Your personal guarantee may still be enforceable even if the bank fraudulently induced you to sign the guarantee. Why? Because when you signed the personal guarantee, you waived the defense of fraud. My advice: know what you’re signing. Before you sign a guarantee with that clause in it, push back with the bank and see if it will remove the clause. If it insists on keeping it, make sure you are fully aware of what you are doing and think carefully about whether or not you want to sign it.
The third thing is your right to revoke the guarantee. If you are a minority shareholder or silent partner, you are likely worried about your personal liability in a non-controlling position. A business may need a great deal of money to grow, and when it does, its debt could increase to accommodate that growth. That means your personal liability could rise as well. Revoking may be an event of default for the borrower under the loan, so it is not a step to take lightly. But if the business is struggling and racking up debt, you may want the option of cutting your losses. For example, say there is an owner in a business that had a 10% stake in the company. He or she signed a personal guarantee. A few years later, the business goes into financial trouble and owes $2 million. If that owner had exercised the right to revoke the personal guarantee at an earlier date, he or she could have limited his or her liability. The point is not that owners should revoke personal guarantees when a business experiences financial difficulties. Rather, it is that they should think of revocation as an option.
Should you sign a personal guarantee? The answer is that it depends. Never agree to a personal guarantee without understanding the scope of your liability. Find out whether the guarantee is limited, unlimited, limited pro rata, and/or whether it includes a waiver of all defenses. Try to negotiate these terms. Remember: If you’re not willing to risk your personal assets if the business fails, be sure you won’t be forced to do so by your personal guarantee.
Already Struggling to Make Its Loan Payments
If your business is already struggling to make its loan payments and your name is on a guarantee, the worst response is to do nothing. Don’t ignore the calls and emails. Take another look at the personal guarantee you signed when you needed the loan, and if you don’t know the answers to these questions, find out now. What will happen if you default? Will your personal assets be at risk? Be informed. Get the answers you need. Once you know your options, you can decide what to do next.
