A personal guarantee is a signed promise to a lender, backed by your personal assets, that you will repay a loan. Based on our own experience at Fit Small Business, more than 80 % of business loans require a personal guarantee.
It’s important to understand what it means to sign a personal guarantee because it makes you personally liable for business loans if the business cannot afford to pay. In this article, we’ll tell everything you need to know about personally guaranteeing a small business loan, including the following:
- What is a Personal Guarantee?
- Why Do Lenders Want You to Sign a Personal Guarantee?
- Who Has to Sign a Personal Guarantee?
- Differences between Personal Guarantee, Collateral, and Liens
- What Assets Are Subject to a Personal Guarantee?
- How to Negotiate a Personal Guarantee
By the time you finish reading this article, you should understand the ins and outs of signing a personal guarantee when you apply for a small business loan. If you’d like information on how to get a small business loan, click here for our ultimate guide.
What is a Personal Guarantee?
When you get a business loan, the lender will usually ask you to sign a promise saying that you will personally pay the loan back if the business goes bankrupt or is unable to pay back the loan. This promise is called a personal guarantee.
If the business is unable to pay back the loan, the personal guarantee authorizes the lender to liquidate your personal assets such as your home, car, and personal bank accounts to repay the debt.
Even if you have structured your business as a Corporation or an LLC (which normally shields you from personal liability for business debts), you are personally responsible for the loan if you’ve signed a personal guarantee and the business is unable to pay.
Most types of small business financing generally require you to a sign a personal guarantee, including the following:
- SBA loans
- Traditional bank loans and business line of credit
- Online alternative loans
- Invoice factoring
- Peer to peer business loans
- Small business credit cards
It’s usually pretty obvious when going through your loan agreement which clause is the personal guarantee. It will typically be labeled as “personal guarantee” or “individual guarantee.” But, if there’s any confusion, ask the lender to clarify. It also doesn’t hurt to have your loan agreement reviewed by an attorney.
Why Do Lenders Want You to Sign a Personal Guarantee?
Lenders want you to sign a personal guarantee because it gives them a secondary source of payment if the business can’t pay back the loan. In addition to that, however, says Rob Wilson, head of SBA lender CEI 7(a) Financing, a personal guarantee also gives the lender added assurance that the business owner(s) are committed to paying back the loan regardless of how the company fares.
If you’re Sergey Brin applying for a loan for Google, you’re obviously not going to be asked to sign a personal guarantee. However, when you’re a small business, you and your business are pretty much one and the same, and there’s an appreciable risk that the business could fail. If you lack confidence in your business’ ability to pay back the loan and are hesitant to sign a personal guarantee, why should the lender trust you with its money? Lenders want you to treat a loan like it’s your own money, and a personal guarantee gives them assurance that you will.
A personal guarantee also prevents you from taking money out of the business to pay yourself, declaring business bankruptcy, and relinquishing responsibility for the loan.
Who Has to Sign a Personal Guarantee?
Lenders have different personal guarantee policies, but in general, the following will need to sign a personal guarantee:
- Anyone who owns 20 percent of the business or more
- Anyone who cosigns the loan
- Spouse of the primary business owner
Remember to always ask a lender about their personal guarantee policy. It may differ for different types of loans and from state to state.
For example, for SBA 504 commercial real estate loans, a spouse who is not part-owner of the business will generally not be asked to sign a personal guarantee. However, in ‘community property’ states such as Arizona and Washington, a spouse who is not part-owner of the business may still be asked to sign a personal guarantee. This is because the laws in those states often protect joint property from creditors unless both spouses sign a personal guarantee.
Personal Guarantee vs. Collateral vs. Liens
One question that often comes up is how personal guarantees differ from collateral and liens. The terminology can get a bit confusing because all of them are designed to protect a creditor if your business defaults on the loan. But it’s important to understand the difference:
- Personal Guarantee – A personal guarantee is a signed promise to pay back the loan if your business defaults. This puts all of your personal assets on the line that aren’t protected by law from creditors.
- Collateral – Collateral is a specific asset or assets that you pledge as security for a loan if the business defaults. The lender can seize the collateral and sell it if the business defaults. It may be a business asset (such as equipment), a personal asset (such as your home), or a combination of both.
- Lien – A lien is the legal mechanism by which the lender can seize your collateral if your business defaults. For example, if you pledge your house as collateral for a loan, the lender will place a UCC lien on it.
Typically, if you default on a business loan, the lender will first liquidate collateral and any business assets that are subject to a lien. If collateral and business assets are insufficient to repay the debt, that’s where the personal guarantee would come in. At that point, the lender will enforce the personal guarantee and seize personal assets to pay off the balance of the loan.
Which Assets Are at Risk When You Sign a Personal Guarantee?
A personal guarantee is a blanket promise. You authorize the lender to liquidate any and all personal assets to repay the debt if the business is unable to pay. This includes things like your car, cash accounts, and vacation home. There are a couple exceptions:
- Your home – Most states have some kind of homestead protection acts that prevent creditors from seizing your primary residence even if you’ve signed a personal guarantee. In some states, there’s a cap on the amount of protection that’s afforded.
- Retirement accounts – Unless you borrow money from a government entity, such as a federal credit union, lenders generally cannot seize your IRAs, 401(k), or certain other retirement accounts even if you’ve signed a personal guarantee. Laws differ from state to state.
You should always check with your bank about its policies, and if you’re in doubt about your state’s laws, consult an attorney.
Small business owners should also be aware that lenders may place a lien on a personal asset, such as your home. If there’s a lien on property, you must ask the lender’s permission before you can pledge that property as collateral for another loan or sell the property. So a personal guarantee is not just about the risk of losing personal assets; it’s also about the hassle of having to ask a lender for permission when you want to sell assets or need additional business financing.
Can I Negotiate a Personal Guarantee?
In general, the answer to this question is no. However, if you are a very strong borrower (i.e. great credit score, high business revenues, etc.), then you may be able to negotiate the following:
- The size of the personal guarantee
- The assets to which the personal guarantee applies
- Who signs the personal guarantee
- Length of the personal guarantee
Size of the Personal Guarantee
If you apply for a $250,000 bank loan to expand your business, the bank will want you to sign a personal guarantee for the whole amount. However, you may be able to negotiate to be on the hook for less.
If you have pledged business collateral for a loan, says Wilson, then you might be able to negotiate a lower personal guarantee. For example, on a $250,000 loan, if you pledge assets the bank values at $120,000 as collateral, you might sign a personal guarantee for only the remaining $130,000.
Alternatively, you can try limiting your exposure to your investment in the business. For example, if you own 30 % of the business, and your business partner owns the rest, you may be able to negotiate with the lender that you should only be on the hook for 30 % of the loan amount. In the example above of the $250,000 loan, that would make you responsible for paying back $75,000 if the business defaults.
Scope of the Personal Guarantee
You may also be able to negotiate which assets the personal guarantee applies to. Some states legally prohibit creditors from coming after your primary residence. If your state isn’t one of them, then you can try to negotiate this into the loan agreement. There’s also generally some legal protection for Individual Retirement Accounts (IRAs), 401(k) plans, pension plans, and some other types of retirement accounts.
Who Signs the Personal Guarantee
You may also be able to negotiate who signs the personal guarantee. If your spouse doesn’t sign the personal guarantee, his or her separate assets won’t be accessible to the creditor.
Timeframe of the Personal Guarantee
Lastly, think about the timeframe of the personal guarantee. Most of the time, personal guarantees can be enforced at any time until the loan is paid back in full. Andrew Goldberg, an attorney and owner of Law Office of Andrew J. Goldberg, says you should try to carve out some protection for yourself by limiting the time during which the personal guarantee can be enforced. This is called a “sunset” provision.
For example, you can tell the bank that you’ll agree to be on the hook for the first 5 years of a 10 year bank loan. That way, if the business goes bankrupt in 8 years, the lender won’t be able to collect on the unpaid debt from your personal assets. Alternatively, says Goldberg, you can ask for the personal guarantee to be released after 24 months of on-time loan payments.
A personal guarantee places your personal assets on the line if your business is unable to pay back a loan. Every small business owner should carefully think about their business’ prospects for success before signing a personal guarantee. After all, it could be your home, car, or other valuable personal assets at stake. Now that you understand personal guarantees, it might be the right time to start shopping around for a small business loan! Read our Ultimate Guide on How to Get a Small Business Loan.