There are some types of loans that don’t require personal guarantees, but most lenders require personal guarantees from small business owners. The personal guarantee pledges personal assets to the lender, which it can pursue if the business defaults. It’s required from anyone that signs the loan, and business owners may be able to negotiate it.
Common topics of interest concerning personal guarantees include:
- What it is: A promise to repay a business loan with personal assets
- How it works: Lenders require borrowers to sign it before funding
- Why lenders require it: Reduces their risk and ensures that borrowers repay funds
- Who must sign one: Owners with 20% or more equity and spouses in some cases
- Types of personal guarantees: Unlimited and limited based on the number of owners
- Common financing products that require it: Some secured and most unsecured business loans
- Assets pledged with a personal guarantee: Includes all personal assets, except homes, retirement accounts, or assets held in trust in some cases
- Negotiating a personal guarantee: Seldom possible and requires stellar qualifications
What Is a Personal Guarantee?
Lenders ask business owners to sign a promise to repay a small business loan if the business cannot make payments. This promise is a personal guarantee. The personal guarantee allows the lender to foreclose on and liquidate personal assets such as a home, car, or bank account to repay the debt.
Why a Personal Guarantee Is Important
Business owners that sign a personal guarantee or individual guarantee can be held liable if the business cannot make payments. Businesses structured as a corporation or LLC protect owners from personal liability but having a business that’s incorporated doesn’t protect small business owners from a lender seeking to enforce a personal guarantee. Although this is generally true, business owners should work with an attorney to understand the risks more thoroughly.
Rocket Lawyer offers small business owners inexpensive one-time attorney consultations and a subscription service for ongoing legal help. Business owners that worry about a personal guarantee or wish to learn how it may impact their business should consider working with an attorney through Rocket Lawyer.
How a Personal Guarantee Works
Borrowers that sign a personal guarantee for a business loan agree to pledge personal assets to cover the debt if the business defaults. This guarantee must be in writing to be enforceable, and both the lender and business owner receive a copy. If a borrower repays the loan, the lender cancels the guarantee. However, if the borrower defaults, the lender can claim personal assets.
If a business defaults on its debts, lenders will pursue business assets first. This may include freezing a bank account, repossessing equipment, or claiming proceeds from a liquidation. If a lender exhausts liens, collateral, and other debt without full repayment, then the personal guarantee comes into play.
Most business loans have terms that make them repayable in full if a default occurs. Here, the lender will file a “demand of debt notice” to enforce the personal guarantee. There is no federal requirement for the time that a lender has to file. However, some states place restrictions on how long a lender has to act. Business owners can negotiate to transfer the liability, extend repayment terms, or otherwise satisfy the debt.
Why Lenders Want a Personal Guarantee
Lenders want a personal guarantee because the borrower has not provided sufficient collateral for the loan. Lenders that offer collateralized loans for equipment or real estate rarely require a personal guarantee. If they do, the asset typically has sufficient value to repay the debt, and the lender does not use the personal guarantee.
Reasons lenders want a personal guarantee include:
- Additional assurance of repayment: Lenders want to ensure that if the business defaults without sufficient assets to repay the loan, personal assets are available.
- Borrowers are in a high-risk industry: Some industries have higher risks of default. While lenders continue to service these industries, a personal guarantee offsets some risk.
- Borrower credit scores indicate high risk: Business owners with poor personal credit may have a great business, but lenders may worry that a low credit score is risky. Business owners should improve their personal credit or consider a bad credit business loan.
- Deterrence of poor behavior: Lenders worry that business owners may take out a business loan, use it to pay themselves, family members, or friends for work and services, and then default. A personal guarantee is a deterrent to this kind of behavior.
“A personal guarantee also gives the lender an added assurance that the business owners commit to paying back the loan regardless of how the company fares.”
―Rob Wilson, former CEO, CEI 7(a) Financing
A personal guarantee may appear only to benefit the lender; however, there are also benefits for borrowers. With a personal guarantee, lenders can offer more funding to borrowers who have high-risk credit profiles or work in risky industries. Lenders can also provide unsecured funding for working capital, which businesses with no available collateral can benefit from.
Who Must Sign a Personal Guarantee
Lenders that require a personal guarantee set the scope for who must sign the agreement. Alternative lenders frequently require business owners with 20% or more ownership in the company to sign. Like other business loans, any co-signers also are responsible for providing a personal guarantee. Sometimes, lenders also require the spouse of the primary business owner to sign.
Parties that must sign a personal guarantee include:
- Any owner with 20% or more ownership of the business: If a business has multiple owners or investors, then lenders require any major owners to sign a personal guarantee.
- Any co-signer that appears on the loan: Lenders require a personal guarantee from every signor on a loan. Lenders do this to protect their interests since they use the co-signer’s assets in the underwriting process, they require the ability to pursue those assets if the business defaults.
- The spouse of the primary business owner: This acts as a deterrent and helps resolve some legal issues of pursuing jointly-owned personal assets like a home. This requirement is more common with large business loans in states that protect jointly-owned personal property.
For example, for Small Business Administration (SBA) 504 commercial real estate loans, lenders usually won’t ask a spouse who is not a part-owner of the business to sign a personal guarantee. However, in community property states such as Arizona and Washington, a spouse who is not a part-owner of the business may need to sign a personal guarantee. The laws in those states often protect joint property from creditors unless both spouses sign a personal guarantee.
Types of Personal Guarantees
Many lenders offer unlimited and limited personal guarantees for which the financial liability of the borrower is the entire loan amount, or a restricted percentage, respectively. The limited personal guarantee applies when multiple owners with 20% or more equity in the business are signing personal guarantees. However, in most cases, a personal guarantee is unlimited.
Unlimited Personal Guarantee
An unlimited personal guarantee requires borrowers to repay the entire loan amount through personal funds or assets in the event of default. This amount includes the entire interest cost, any remaining principal, and any legal or administrative fees incurred by the lender to collect the fee. This is the personal guarantee that’s most common with businesses that have sole owners.
Lenders collecting on a loan for $100,000 in unpaid principal and interest that incur $10,000 in legal fees can claim up to $110,000 from the borrower. An unlimited guarantee does not offer any protection to borrowers and can be a major liability if the business defaults. If the business does not make payments, this guarantee can devastate the owner’s personal assets.
Limited Personal Guarantee
Lenders that require a personal guarantee for a business loan understand that a business owner with a 20% interest in the business may be uncomfortable with accepting the liability of the entire loan. To address this problem, lenders created a limited personal guarantee. This guarantee restricts the liability of a borrower to a certain percentage of the loan.
Limited personal guarantees include:
- Several guarantees: Lenders can sometimes use the total percentage of ownership in the company of each party to set a maximum for liability. Each party is responsible for a predetermined portion of the debt and nothing more. Lenders use the percentage ownership to determine the liability.
- Joint and several guarantees: With joint and several guarantees, each business owner is responsible for a set percentage, unless the lender does not collect the entire amount. In that case, the lender can hold each party liable for the total loan amount. So, if a business partner disappears, the other guarantors pay the difference.
Lenders that pursue personal assets from several business owners with a limited personal guarantee can collect a certain share of the loan from each guarantor. Two guarantors can each owe half of $100,000 plus the $10,000 in legal fees to the lender. In this case, each individual has liabilities of $55,000, but owners need not share the responsibility evenly. If there are joint and several guarantees, any money that one business owner cannot contribute becomes the responsibility of the other guarantor.
Common Financing Products Requiring a Personal Guarantee
Lenders don’t require a personal guarantee for every financing product. Most personal guarantees that lenders require are for financing products that are designed for high-risk borrowers or ones that have no collateral for security. The best business loan brokers can help borrowers find financing that doesn’t require a personal guarantee.
Common types of financing that require a personal guarantee include:
- SBA loans
- Business lines of credit
- Online alternative loans
- Peer-to-peer business loans
- Small business credit cards
Like with every rule in financing, business owners will find exceptions. There are some no personal guarantee credit cards for business, and some lenders may offer small-dollar amounts without a personal guarantee requirement, which is common with the best invoice financing companies.
Assets Pledged With a Personal Guarantee
A personal guarantee puts all personal assets at risk if a business defaults on its payments. In some states, some laws protect certain assets and shield them from lenders, even if a borrower signs a personal guarantee. Business owners should be aware the laws rarely protect vehicles, cash accounts, or vacation homes, and it’s best to consult an attorney for specific questions.
Common exceptions to the assets borrowers pledge with a personal guarantee include:
- Primary residence: Most states have some kind of homestead protection act that prevents creditors from seizing a primary residence. This protection also extends to borrowers that sign a personal guarantee. However, not every state offers this protection, and some states limit the number of protections borrowers can receive.
- Retirement accounts: Laws prevent lenders from seizing assets in a retirement account like an individual retirement account (IRA) or a 401(k). However, there are exceptions, which include loans that the federal government originates like SBA disaster loans and financing from federal credit unions. Like primary residence protection, individual state laws vary as well.
Business owners should always check with a lender about its policies, and if there is any doubt, it’s best to consult an attorney. It’s also important to keep in mind that a personal guarantee may prevent or slow down the guarantor if they need to sell a personal asset like a home. Lenders may even request to further secure their interests with a lien, which can make the asset unsellable and may make it difficult to qualify for other types of financing.
Negotiating a Personal Guarantee
Most business owners that borrow from traditional and online lenders won’t be able to negotiate a personal guarantee. Business owners with an excellent credit history, a well-established company, and high annual revenue that is continuing to grow may have enough leverage to negotiate. This scenario is most common with doctors that have a well-established practice.
“If the timing is right, you can negotiate yourself out of a personal guarantee. The best time to revisit negotiations is when the financial standings of the company improve significantly. Impressive financials might help you negotiate away additional terms of the loan that aren’t in your favor.”
―Simon Nowak, CEO, 3 Credit Scores
Factors that business owners can negotiate in a personal guarantee include:
- Size: Business owners may negotiate the size of their responsibility on a personal guarantee. One way to reduce the size of the guarantee is by providing some collateral and only guaranteeing the difference. If there are multiple business owners, then it’s possible to negotiate a smaller guarantee percentage based on ownership.
- Scope: Reducing the scope of a personal guarantee is more difficult but possible. Sometimes, local laws will reduce the scope by eliminating a primary residence from the guarantee. Some business owners may also carve out certain personal assets by working with the lender.
- Responsible parties: Business owners may negotiate a reduction in the number of guarantors for a loan. Although this is difficult for other owners with equity in the business, it is sometimes possible for a spouse. However, borrowers may have to show that the business owner has sufficient nonjoint assets.
- Length: A good way to reduce the potential risk and liability of a personal guarantee is by reducing the time it is active. A personal guarantee will typically be enforceable as long as the debt is outstanding. However, business owners can negotiate a shorter time frame, like 2 years, after which the personal guarantee will expire.
“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.”
―Andrew Goldberg, Owner, Law Office of Andrew J. Goldberg
Business owners should avoid negotiating a personal guarantee on their own because it will rarely produce positive results. Instead, business owners that believe they have sufficient leverage to negotiate should enlist the help of an attorney to negotiate for them. An attorney will have a better understanding of the applicable laws and is more likely to produce good outcomes.
Alternatives to a Personal Guarantee
Lenders also use collateral and liens to secure business loans and ensure repayment. Sometimes, business owners must provide all three to qualify for funding, but there are cases in which a lender will skip a personal guarantee for a different form of collateral. Each one is important, and business owners should understand the major differences between them.
Collateral is a specific asset or assets that business owners 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 a home, or a combination of both.
A lien is a legal mechanism by which the lender can seize the collateral if the business defaults. For example, if a business owner pledges business property as collateral for a loan, the lender will place a Uniform Commercial Code (UCC) lien on it. It is common practice for lenders to place a blanket UCC lien, which covers all available business assets.
Lenders that require all three will first liquidate collateral and any business assets 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.
Personal Guarantee Frequently Asked Questions (FAQs)
Business owners that plan to sign a personal guarantee or have one on their records often have questions specific to their situation. Below, we answer some questions that business owners ask frequently about personal guarantees. We invite business owners with any additional questions to post them in the Fit Small Business forum.
Is a personal guarantee legally binding?
A personal guarantee is legally binding if it is recorded in writing and signed by the guarantor. If this is not the case or a business suspects that it may not need to adhere to a personal guarantee, it’s best to hire an attorney for the matter.
Can you get out of a personal guarantee?
There are two primary ways that business owners can get out of a personal guarantee. The simplest way is to repay the debt to the lender. The second way if by filing for personal bankruptcy relief so the lender cannot pursue business debts. Business owners considering bankruptcy should consult an attorney.
What happens if you default on a personal guarantee?
Defaulting on a personal guarantee can lead to legal proceedings and will impact the personal credit score of the business owner. The damage to the credit score is difficult to remove, and it may be visible to other lenders for a decade. Business owners that are at risk of default should consult an attorney.
A personal guarantee places the personal assets of a business owner at risk if the business cannot make payments. Every small business owner should consider the risks before signing a personal guarantee. Sometimes, there are steps business owners can take to negotiate the scope of the guarantee or eliminate it.