What is a Personal Guarantee and Why Do Lenders Ask For One?
Seeking funding to grow your small business is, in the best of circumstances, a process filled with new possibilities.
At the same time, the thought of taking out a small business loan can come with some insecurity and intimidation as you learn the language of small business lending and wrestle with the risks and rewards of taking on debt for your business.
For many entrepreneurs, that intimidation factor reaches its strongest point on the subject of signing a personal guarantee for your business loan.
If you’ve come across the term personal guarantee within your business loan agreement, you may have had a flurry of questions: What is a personal guarantee? Do all lenders require one? What does it mean for your business and personal finances?
Here’s what you need to know about personal guarantees before you commit to a business loan.
What is a Personal Guarantee?
Simply put, a personal guarantee is a legally binding contract provision often included as part of a small business loan agreement in which the individual applicant—almost always the small business owner—agrees to be held personally liable for the repayment of a loan in the event that your business is unable to repay its debt effectively.
The personal guarantee ties you as the individual financially to your business with regard to your loan agreement, meaning you are personally responsible for the debt regardless of whether your business venture succeeds or fails.
Why Lenders Request Personal Guarantees
From a lender’s perspective, loaning money to any small business—and particularly to a relatively new business venture—is typically considered a high-risk loan. After all, lenders know that a significant number of small businesses do not succeed past their first few years.
To mitigate the risk of this investment, lenders want to know that you’re willing to be personally responsible for the repayment of your loan.
On a psychological level, this shows that you have a significant stake in the success of your business. And from a business standpoint, it gives the lender some legal recourse to recoup the investment in the event that your business defaults on its debt.
The Downsides of a Personal Guarantee
Unfortunately, the downside of a personal guarantee for you as the borrower is that it puts a tremendous amount of risk on you in the event that your business defaults..
Essentially, a personal guarantee says to the lender that if your business is unable to repay its debt, you as an individual owner can be held 100% responsible for whatever balance remains on that debt at the time.
And because that personal guarantee applies to all levels of your finances (and not just a single asset as is the case of collateral), the lender is legally within their rights to pursue any aspect of your finances—including your child’s college fund, your retirement accounts, your personal savings, or any other wealth you hold now or in the future—in order to recuperate its investment.
Alternatives to the Personal Guarantee
Although personal guarantees are a relatively common practice within small business loan lending, there are certain alternatives you can pursue in order to avoid signing a personal guarantee if you’re not comfortable with or are unable to go in that direction.
Offering Personal Collateral
Many business loan applications allow borrowers to put up a specific personal asset as collateral to guarantee the loan in lieu of a more general personal guarantee. In this scenario, you would sign away your rights to a specific asset such as your family home in the event that your business default on the loan.
Obviously, the potential of losing one’s family home is by no means an enviable situation—but this is considered a relatively lower risk scenario as compared to an unlimited personal guarantee because it limits the lender’s access to your personal wealth to the one asset.
However, because of this limitation, it’s important to note that collateral loans are often not available for borrowers seeking a large amount of funding—especially if that amount is significantly more than the value of the asset that you have available as collateral.
There are alternative forms of financing that don’t require personal collateral or a personal guarantee at all. Asset-based loans are ones in which an asset within the business acts itself as collateral on the loan, no personal collateral is needed from the business owner.
One common version of asset-based lending is an equipment loan, in which the equipment being purchased can be repossessed in the event of a default.
Purchase order financing and invoice financing are other common asset-based lending options. In these cases, the value of the purchase order or the invoice is considered collateral on the loan, and the lender can pursue those payments directly from your customer in order to cover the cost of the loan.
How to Protect Your Finances When Taking Out a Business Loan
Although avoiding loans that require a personal guarantee may seem like the only way to protect your personal finances, the reality is that in some cases, signing a personal guarantee may be unavoidable.
Yet regardless of whether you’re carrying the full weight of personal liability for your business debt, the best way to truly protect your personal financial security has far more to do with making sure that you are handling your business finances responsibly.
By requiring you to sign a personal guarantee, your lender is first and foremost asking, “Are you sure that you’ve thought this through?”
Any seasoned entrepreneur can tell you that growing a small business is a process that never goes exactly according to plan. Mistakes will happen. The market will shift. The roof will leak.
That’s why, before committing to any small business loan, you need to know two things with utmost certainty:
Are the funds you borrow going towards a smart business investment?
Can your business maintain the necessary cash flow to consistently cover your loan repayments?
When you can answer those questions with a resounding yes, you will be ready to sign the dotted line on your small business loan agreement with or without a personal guarantee.
Jared Hecht is the co-founder and CEO of Fundera, an online marketplace to help business owners secure financing. Prior to Fundera, Hecht co-founded group messaging app, GroupMe.