Types of Personal Guarantees
E.J. Simonsen | Aug 8, 2022
Getting funding for a small business, especially a new small business, can be tricky. From applying for business loans from various lenders to choosing the right financing option for your company, there's a lot to consider. And a lot of legal jargon and fine print doesn't help. In fact, many lenders require a personal guarantee as a key element in the business loan's fine print, but this can put your personal finances at risk.
Not all business owners know what a personal guarantee is or how it can put them at financial risk. That's why we're putting together this article about the types of personal guarantees available to business owners. Here's everything you need to know about what a personal guarantee is, what kinds of personal guarantees there are, and which is best for you and your business:
What is a Personal Guarantee?
Before we dive into the different types of personal guarantees, let's first make sure we have a clear definition of a personal guarantee.
A personal guarantee is a provision in a loan whereby an individual is personally responsible for a debt in the event the borrower defaults.
How does this definition apply to various business debts, loans, or other financial obligations in which the borrower is not another person but the business itself?
A personal guarantee is a contractual provision where the business owner(s), or other individual(s), accepts personal responsibility for the business’s financial obligation, such as debt, cash advance, loan, or other legal obligation, in the event that the business defaults on such obligation.
Personal guarantees aren't required for every business loan, but they are likely when a new business is applying for a loan or when a business doesn't have significant collateral. The purpose of a personal guarantee is to lessen the lender's risk when they give you a loan.
With a personal guarantee, even if the business defaults on a loan, your lender still has you to fall back on. They're less likely to lose all of the money loaned to the business if they can recoup some or all of it from your personal finances.
What are the Main Types of Personal Guarantees?
In general, personal guarantees fall into two categories:
- A promise to pay
- A promise to perform
In this blog, we will cover the most frequently used personal guarantee type, which is the promise to pay.
There are two types of "promise to pay" personal guarantees: limited and unlimited.
1. Limited Personal Guarantees
A limited personal guarantee means the guarantor (the person who signed the personal guarantee) is still personally liable for debts the business cannot pay, but only to a specified limit. With a limited personal guarantee, a business owner might still be on the hook for some of the business's debt, but there are limits to how much that person will pay. Depending on the limited personal guarantee you sign, the limit could reduce either:
- The dollar amount you are liable for
- The percentage of the loan you are liable for
- The time span of the loan
SBA loans offer a good example of a limited personal guarantee in action. Many SBA loans use a limited guarantee which includes the following loan reduction options:
- Balance reduction — When your loan balance drops below a certain amount, your balance to pay is reduced.
- Principal reduction — When the loan principal drops below a certain amount, your principal is reduced.
- Maximum liability — There is a maximum dollar amount for you to pay that is less than the total cost of the original loan and outstanding fees.
- Percentage — You are liable for a certain percentage of the loan, which typically includes interest and other fees.
- Time — When a maximum amount of time lapses, you are no longer personally liable for the outstanding balance.
- Collateral — Provided collateral, like property, equipment, or some other asset, takes the place of the personal guarantee.
- Community property or spousal interest — If you own property jointly and the other party's interest in the pledged collateral is exempt from enforced collection, you may not have to sign that asset over to the lender.
These examples show the heart of a limited personal guarantee — the amount of the loan you are personally responsible for is less than the original cost and interest fees associated with the loan. While this doesn't exempt you from liability, it can make the costs, if they occur, a little easier to bear.
2. Unlimited Personal Guarantees
An unlimited personal guarantee means that you, the guarantor, must pay all amounts due until what was lent to the business is paid in full.
If you sign an unlimited personal guarantee, you have to pay 100 percent of what is owed if the business defaults on that loan, including any default or collection expenses. In this situation, you could stand to lose any asset that could help cover the cost of the loan.
For example, the SBA may require an unconditional personal guarantee from business owners with a 20% or greater stake in a business applying for an SBA loan.
If the business is granted the SBA loan but eventually defaults, that business owner is then entirely responsible for the rest of that loan, including interest and fees.
3. What About "Bad Boy" Guarantees?
It's true that there is such a thing as a "bad boy" guarantee, but since it is typically written into a limited personal guarantee, it's not really its own type of personal guarantee.
That said, it's still important to understand and be aware of. A "bad boy" guarantee often converts a limited personal guarantee into an unlimited guarantee if the guarantor does something illegal or unethical like:
- Misappropriating funds
- Committing fraud
- Unauthorized transfers of collateral
While this might sound extreme, "bad boy" guarantees provide another layer of protection for lenders.
Which Type of Personal Guarantee is Better?
As you might expect, a limited personal guarantee is the better option for most businesses because the business owner is liable for less of the loan. That said, if you're applying for business loans, it's best to try personal guarantees altogether, if you are able.
How Can I Avoid a Personal Guarantee?
The best way to avoid a personal guarantee is to either put up a good faith cash deposit or choose a secured loan instead of an unsecured loan. With a secured loan, the business's collateral (property, machinery, or some other asset) takes the place of the personal guarantee, freeing you up from liability in case the worst happens.
Unfortunately, a secured loan isn't always possible for some new or small businesses, and sometimes even when it is the lender may still require a personal guarantee. If your business is struggling to avoid a personal guarantee, it's always best to talk to a professional before signing anything.
A qualified CPA and business debt relief attorney can provide helpful insight into what is best for you and your business before you become liable for business debt you might not be able to afford.
If you're still unsure which type of personal guarantee is best for you, or even if you should have one, talk to an attorney you can trust. The Lane Law Firm's business debt relief attorneys are here to help you find the best solution for your concern. Get in touch with us online or by phone today for immediate support!