You’re applying for a business loan. As you go through the process, you see something in the documents you didn’t anticipate—a personal guarantee.
Generally, business owners may be surprised to learn that they are going to be asked to sign a personal guarantee to borrow money. But, there is a reason it is required and even some advantages to giving it.
Below are some insights as to the reasoning, history and benefits of a guarantee, so you can be prepared in the event one is required.
What is a personal guarantee?
A personal guarantee is your legal promise to pay the debts of your firm in the event that the firm defaults. It lessens the risk to your lender while giving you access to the funds you need to operate and pursue growth opportunities for your firm.
How did it become a requirement to a loan?
After the savings and loan crisis of the 1980s and 1990s, federal and state regulators required heightened standards for loan documentation, including the addition of personal guarantees. This was, at least in part, because many banks prior to the crisis did not ask for them. When a business failed, the banks suffered a loss and couldn’t seek recourse against the individuals responsible for owning and managing the business—leading to what was referred to as the most significant bank collapse since the Great Depression.
As a result, bank regulators adopted a rule requiring limited or unlimited personal guarantees of any shareholder with over 20% ownership in the company. This 20% ownership rule is more or less seen as the standard of private lenders too, even though they are not required to implement it by a regulatory body.
My lenders know me—don’t they trust me?
Your lender knows you, your integrity and the way you run your business. So, when your lender requests a personal guarantee to borrow money for your business, it can be puzzling.
Don’t take it personally!
Most people don’t apply for a loan with the intention of not paying it back. But, the reality is that not all businesses succeed. You can’t predict the future and neither can your lender.
Lenders require your personal guarantee as an “added assurance.” This is especially necessary to hedge risk for a lender when providing a loan to a small- or medium-sized firm owner whose personal finances are intertwined with the business. In that circumstance, a spouse may also be required to give a guarantee.
Also, keep in mind that lenders do NOT like pursuing the assets of individual guarantors of a loan. It’s often helpful to discuss with your lender their preferred approach in the unlikely event you are unable to meet the agreed upon terms of your loan. Most lenders will much prefer to work out a resolution by amending loan terms over placing a loan in default and pursuing a guarantee.
What are the advantages to signing a guarantee?
Without question, the primary benefit of providing personal guarantees is that it can significantly increase the likelihood of obtaining a loan in the amount you desire and under more favorable terms. Since guarantees are all about providing lenders with additional security, a guarantee from an owner of a firm or equity partner can go a long way.
Additionally, signing a personal guarantee can also create a tax advantage for the guarantors as it typically increases the borrower’s tax basis. Be sure to address this with your tax professional to determine what level of benefit you can gain if you have committed to a guarantee.
Signing a personal guarantee should be carefully considered in any business transaction. However, often times the benefits can outweigh the additional risk.
The following article is part of a collaborative educational blog series, Finance Corner: A Guide for Plaintiffs' Attorneys and their Clients. If you are interested in receiving similar articles, you can subscribe here.
Counsel Financial provides working capital credit lines exclusively for the plaintiffs' bar in all states except California, where credit lines are issued by California Attorney Lending.