A Personal Guarantee
When your business is struggling to make its loan payments, one question tends to keep owners up at night: am I on the hook for this personally? If you signed a personal guarantee, the answer is probably yes. A personal guarantee (sometimes spelled “guaranty”) is a promise that you, as an individual, will repay the business loan if the company can’t. At first glance, the idea of you paying back the loan when your business can’t seems unfair. But lenders ask for personal guarantees because they want security. Your business’s stability matters to them, and a personal guarantee ensures they can still get their money back even if things don’t go as planned. It’s their safety net.
Many lenders require that at least one of the owners of the business personally guarantee the debt, especially if the business is new. They also look at your credit history and how stable the company’s finances are. How your business is set up matters too. If you’re operating a sole proprietorship or general partnership, the law regards you and the business as one and the same. But if you’ve formed an LLC or corporation, you have a shield that generally protects your personal assets. The catch is that when you sign a personal guarantee, you are promising to personally repay the debt if the business can’t pay. This promise applies no matter the form of your business. You are personally liable for any debts or obligations for which you personally promised to pay.
There are two main kinds of personal guarantee. Unlimited, also known as unconditional, personal guarantees require you to pay everything due until the loan is paid in full. The SBA may require one from anyone who owns 20% or more of a business applying for an SBA loan. A limited guarantee reduces the total dollar amount, time and/or percentage of the loan you’ll be held responsible for. On an SBA loan, the guarantee might end once the balance of the loan is less than a specified dollar amount, the principal balance is less than a specified amount, a specific maximum dollar amount is paid, a specific percentage of the loan amount (plus interest and costs) is paid, a maximum amount of time has elapsed, or collateral replaces your guarantee. Finally, a spouse’s interest in community property might be exempt from SBA collection enforcement. Your lender decides and your SBA loan will have only one.
A “bad boy” clause (also known as a carve-out) will increase a borrower’s personal liability for a default if they have done something illegal or unethical. It’s used most often in commercial real estate transactions and can provide the lender with added security. Examples of violations include fraud, misapplication of funds, unauthorized transfer of mortgaged property or other collateral and bankruptcy.
Defaulting on a Loan You’ve Guaranteed
So what happens if the business actually defaults? The main danger is that you become liable for the loan. If a partner or family member co-signed, they are also on the hook. Some loan documents may have a confession of judgment clause, which means a lender can obtain a court judgment against a borrower without going through a standard lawsuit. Your credit score will drop, both business and personal. It can also result in the loss of assets tied to the guarantee, such as equipment, a home, or a car. If you used a checking, savings, or retirement account as collateral, the lender may have the right to seize those balances as well.
Business credit is tracked separately from personal credit by different credit bureaus, so defaulting on a loan you’ve guaranteed can show up on both your credit reports. Missed payments may hit the business file first, but once a lender begins to go after an owner personally, such as by hiring a collection agency or winning a court judgment, that information is reflected in the owner’s personal credit score as well. A collection or court judgment can remain on your personal credit report for up to seven years, so the damage can last well after your business has closed.
If you haven’t signed yet, you may have options. One way around this is to get a secured business loan. With a secured loan, you pledge specific assets, such as equipment or property, as collateral for the loan. If you default on the loan, the lender can only collect the pledged asset and not all of your personal assets, so the maximum risk is limited to the value of the pledged asset. If that is not an option, you can ask the other owners of the business to cosign the guarantee, so that each of you would only be liable for a proportional share of the debt, or have them sign an agreement promising to reimburse you if the bank ever comes after your personal assets. That way, your liability is spread out.
If you do sign, it’s a good idea to ask the lender if you can sign a limited guarantee instead of an unlimited guarantee, and what conditions must be met to be released from the guarantee. You should also ask the lender if you can pledge your property as collateral to reduce the amount of your guarantee. Ambiguous wording in your guarantee will allow the lender to interpret the agreement in the manner that costs you more, so it’s important to ask questions about the wording before you sign. It’s also important to avoid signing a “continuing guarantee,” which means the guarantee remains effective until it is revoked, and it covers past, present and future loans with the same lender, even after the original loan agreement has expired. Also beware the language ‘joint and several’: the lender can go after you for the whole amount owing even if co-owners have signed the guarantee.
What about a guarantee you’ve already signed? The contract can be revoked if the guarantor and the lender agree in writing (usually when the borrower has paid off the loan, or when it’s refinanced or replaced by sufficient collateral). You can also have the debt discharged in personal bankruptcy, but it depends on the type of bankruptcy you filed and whether the debt qualifies for discharge under the U.S. Bankruptcy Code.
If your business is already behind, start with the paperwork. Get a copy of the guarantee. You need to read it from cover to cover. Don’t rely on your memory or the bank’s word. Then ask: How exactly are you supposed to be released from it? If there is no limit, you could be on the hook for the whole loan. Even though it seems unfair, the reality is that when you sign a personal guarantee the law expects you to keep your word. But knowing exactly what you signed tells you what is at stake, and a lawyer can look at your actual loan agreement and answer the key questions.
