Small businesses make a huge contribution to the U.S. economy. Nevertheless, starting a new business is risky. Lenders view loans to small businesses, particularly start-ups, as among the riskiest they make, particularly when there is little or no credit history or business revenue on which to base their decision. In an effort to lessen their risk, lenders frequently require small business owners to sign personal guarantees as a condition for giving the loan. A personal guarantee is a legal commitment by a business owner to repay a business debt if the business is unable to repay it. These guarantees put the personal assets of small business owners on the line—savings accounts, cars, homes, and retirement funds. However, there are several steps you can take to minimize your liability.
Request limitations on when the guarantee goes into effect. Try to include terms allowing the personal guarantee to be utilized only once a certain number of payments have been missed or if the net worth of the business decreases below a specific amount.
Ask for the amount of the personal guarantee to be decreased over time as the business grows. Once your business has stabilized and established a good track record of creditworthiness, the amount of the personal guarantee could be reduced.
Seek a limited personal guarantee based on ownership percentage. Unless you negotiate other terms, lenders are likely to try to establish an unlimited personal guarantee. This allows the lender to collect 100% of the loan amount, as well as attorneys’ fees, from an individual business owner, even if there are multiple owners. It is important to avoid this “joint and several” liability, which allows the lender to recover the full amount from you if the other owners no longer have sufficient personal assets to cover the loan. Even if you only have a 50% stake in the business, you would be personally liable for the entire amount of the loan. Instead, seek to limit your personal liability based on your ownership percentage in the business.
Ask for certain assets, such as your home or retirement account, to be expressly excluded from the scope of the guarantee. Some states have homestead statutes that exempt primary residences from being sold to meet the demands of most creditors or limit the amount creditors can recover from the sale.
Agree to pay a higher interest rate–you may be able to eliminate or limit the need for a personal guarantee by doing so. It is important to evaluate the pros and cons of a higher interest rate, however, as the profits your business generates will be reduced by higher interest payments.
Remember: Establishing a business structure providing limited liability, for example, an LLC, will not protect you from liability under a personal guarantee.
Lenders are likely to include terms in small business loans providing extensive personal liability. It is essential to seek legal counsel to explain the full ramifications of a personal guarantee before you sign on the dotted line. We can help you negotiate terms that will minimize your liability and maximize protections for your assets (and your credit rating).