Odds are if you’re buying a commercial building to operate your business in and you lack a long history of repaying debt, your bank is going to want some kind of personal guarantee from you. You may not have to provide a personal guarantee on your bank loan if you own a well-established company. But exactly what is a personal guarantee? In this post we’ll cover:
- What is a Personal Guarantee?
- Why Do Lenders Require Personal Guarantees?
- Types of Personal Guarantee
- What are Some Personal Guarantee Alternatives?
A personal guarantee is exactly what it sounds like: a guarantee that you, as an individual, will pay back a loan for your business.
The Ways They Could Collect
Banks and other lenders need to believe they can collect on the loan one way or another. They put the ways they could collect roughly in the following order:
- Cash flow. The most preferred form is cash flow from either rents from tenants or sales of units or lots.
- Assets. Is there enough collateral to pay off the loan should there be a default?
- Owner’s personal guarantee. In the event that default occurs and all collateral has been seized, will there be additional assets to pursue?
Say the project defaults and the bank forecloses. If there’s still money owed after all the collateral has been seized and sold, the bank comes calling.
But it’s not a lot of fun when the guarantor has to make up the shortfall with their own cash. There are a few different ways you could guarantee a bank loan on commercial real estate.
To be perfectly frank, lenders like as much assurance as they can get that they’ll be repaid. They want protection, so you should expect a lender to press for as strong a personal guarantee as they can get.
When you take out a bank loan as the sole owner, the lender may ask for a sole guarantee. This means that one person, usually the business owner, will serve as the loan’s personal guarantor.
When taking on a personal guarantee, watch out for unintended consequences. If the guarantor also holds cash and other investments jointly with their spouse, the spouse’s money is effectively also on the hook too. The spouse should know about that guarantee in advance of it being signed.
A joint guarantee is when two or more people agree to be personal guarantors on a business loan. If you are taking out a loan with a partner, the lender may want a joint guarantee.
If the project defaults, all the guarantors owe as a group. If the personal guarantors have to pony up, it’s up to them how they want to apportion their responsibility. For example, say a loan is for $1 million and collateral sells for $800,000. There’s a $200,000 shortfall. They might pay $100,000 each. Maybe one guarantor pays $150,000 and the other pays $50,000.
The downside of a joint guarantee is that the shares aren’t spelled out, so guarantors can get into a big argument about who pays what.
A joint and several guarantee takes a joint guarantee one step further. Each guarantor is jointly responsible. In addition, each guarantor is also individually responsible for the whole amount. Banks prefer joint and several guarantees. It gives them the most flexibility in how they pursue outstanding debts.
The lender has the option to collect 100% of the outstanding debt from one or both of the guarantors. The lender doesn’t even have to go after every guarantor. If one guarantor is judgment proof, it may never bother with them.
Let’s go back to that loan shortfall of $200,000. Partner A suddenly has nothing but pocket lint. Partner B is forced to pay all $200,000. It’s like going to lunch with a friend who realizes they don’t have their wallet, so you end up paying the whole bill.
The structure of joint and several creates an environment ripe for future disagreements. Get to know the other party’s assets well in advance and be sure of their ability to make good on their promises, lest they one day “forget their wallet” at the lunch table.
Limited personal guarantees are when the guarantors are only liable for a predetermined maximum amount.
Go back to that $200,000 shortfall on the $1 million loan. Assume the guarantee is capped at $150,000. The guarantor pays $150,000, and the lender writes off the other $50,000 as a loss.
A declining guarantee is when the amount of the personal guarantee decreases over time. With a declining guarantee, the liability decreases in tandem with the decrease in the debt. The guarantee steps down at predetermined milestones. It’s common on loans for projects that are sold off, like condos or single-family lot developments.
Picture a developer that purchases a tract of land with the intent to split it into smaller lots and sell to homebuilders. Each time a lot is sold and the loan’s principal is reduced, the personal guarantee amount is reduced.
Truth is, once a lender requires a guarantee, borrowers often don’t have much leverage. Some structures are needlessly harsh. There are two ways you can push back, to negotiate structures that leave you better protected.
The first way to push back is to look at other lenders. Odds are the next bank will want a guarantee too. But tell them right away that you’d prefer not to sign one. Some lenders are pickier than others, and you may find one that agrees.
The second option is to pledge collateral instead of giving a guarantee. You might offer to pledge cash, securities or more real estate than the loan requires. That gets sold off only if there’s a shortfall, and only enough of it is sold to cover the shortfall.
In all likelihood, the bank will ask for some sort of guarantee. Understanding each type of guarantee is crucial as you work out your bank financing.
About Delancey Street
Delancey Street is a premier, and award winning, business debt settlement company that helps business owners nationwide. Our goal is simple: help you escape debt in a safe and legal manner. Based out of New York, we can help in 49 of 50 states. We tell you how it is; because your business and future is on the line.
