Understanding Personal Guarantees in Small Business Financing

When searching for small business financing, a term that often pops up is “personal guarantee.” It might sound old fashioned — like something that involves nothing more than a handshake and a smile — but borrowers should take them seriously.

In many ways, a personal guarantee can benefit both the borrower and the lender. They create an added level of security, reducing risk for lenders and sometimes improving the chances of approval for borrowers. However, in the event of default, a borrower’s personal finances are on the line.

Before you enter a personal guarantee, it’s important to understand exactly what the term means. Here’s what you should know.

What Is a Personal Guarantee?

A personal guarantee is a commitment to assume responsibility for a business loan. Typically, it is made by the business owner or a key executive. A borrower who enters a personal guarantee is known as a “guarantor.” Personal guarantees are legally binding.

Many small business lenders require personal guarantees. They act as a safety net, reducing the risk to the lender when approving a loan. This can increase their confidence when approving a loan.

For borrowers, personal guarantees can be an important tool. They can help small businesses — especially those with limited credit history or assets — gain access to capital.  However, it’s important for borrowers to take them seriously. In the event of default, a personal guarantee can potentially put the borrower’s personal finances and credit score at risk.

How Do Personal Guarantees Work on Business Loans?

When a business applies for a loan, the lender may require a personal guarantee from the borrower. This holds the guarantor of the personal guarantee personally liable if the business defaults. It’s important to note that this is true even if the business operates as a separate legal entity (like a limited liability company or corporation).

Personal guarantees are a way to make the lender more confident that the loan will be paid back. This is especially important when lending to startup businesses that are still building credit history or lack suitable collateral.

Types of Personal Guarantees

When it comes to securing a small business loan, lenders often seek assurances beyond the business’s assets. Personal guarantees play a significant role in providing that extra layer of security. However, not all guarantees are created equal. Different types of personal guarantees come with different legal obligations. Understanding them can help small business owners navigate these agreements and make informed decisions about their financial commitments.

Unlimited guarantees

An unlimited personal guarantee holds the guarantor responsible for the entire loan amount, including the principal, interest, and any associated costs. Guarantors under unlimited guarantees have no cap on their personal liability. In the event of a business default, they can be pursued for the full extent of the outstanding debt. This type of guarantee poses the highest level of personal risk.

Limited guarantees

Limited guarantees set a specific cap on the guarantor’s liability. This means that the guarantor is only responsible for a predetermined amount of the outstanding debt. While limited personal guarantees provide some protection by capping the liability, the guarantor is still on the hook for the specified amount. It offers a middle ground between offering substantial security to the lender and limiting the guarantor’s exposure.

Several guarantors

In some instances, lenders may seek personal guarantees from multiple individuals associated with the business, typically the business partners. With several guarantors, the responsibility for the loan is shared. Each guarantor is individually responsible for the entire debt, providing flexibility for lenders to pursue repayment from any or all guarantors.

Joint and several liability

Joint and several liability means that each individual guarantor is collectively and individually responsible for the entire debt. This type of guarantee increases the lender’s flexibility to pursue repayment. If one guarantor is unable to contribute, the lender can turn to others to recover the full amount owed. It places a significant burden on each guarantor to cover the total debt if others are unable to contribute.

What Is Included in a Personal Guarantee for a Business Loan?

Understanding what’s included in a personal guarantee is essential before signing an agreement.

Loan repayment. The primary obligation outlined in a personal guarantee is the commitment to repay the outstanding loan balance if the business defaults on its payments. This includes the principal amount borrowed from the lender. The guarantor becomes personally liable for ensuring the loan is repaid according to the terms agreed upon in the loan agreement.

Interest and fees. Apart from the principal amount, a personal guarantee often extends to cover accrued interest, penalties, and other charges associated with the loan. In the case of default or late payments, the guarantor could be held responsible for these additional costs.

Collateral. Lenders may require collateral as security against the loan. In the event of business default, the lender can seize the pledged collateral to recover the outstanding loan amount. Personal guarantees often require that the guarantor’s assets (such as real estate, vehicles or savings accounts) may be used as collateral, which puts them at risk if the business fails to meet its repayment obligations.

Legal implications. Personal guarantees are legally binding contracts, and breaching the terms can have serious legal consequences. Guarantors should be aware that defaulting on a personal guarantee could result in legal action. This could include judgments against personal assets, wage garnishments, or liens on property.

Do All Business Loans Require a Personal Guarantee?

While many business loans (such as term loans and lines of credit) may require a personal guarantee, there are certain types of loans or financing options where a personal guarantee is not always mandatory. However, keep in mind that the absence of a personal guarantee might be compensated by collateral or higher interest rates. Here are some types of business loans that may not always require a personal guarantee:

Secured loans. Loans secured by business assets, such as equipment, inventory, or accounts receivable, may not always require a personal guarantee if the collateral is sufficient to cover the loan amount.

Invoice financing. Invoice financing or factoring involves borrowing against outstanding invoices. In some cases, lenders may be more focused on the creditworthiness of the clients whose invoices are being financed, and a personal guarantee might not be necessary.

Equipment loans. Loans specifically for purchasing equipment may not always require a personal guarantee if the equipment itself serves as sufficient collateral.

Business credit cards. While not a traditional loan, business credit cards often do not require a personal guarantee. The credit limit is usually determined by the business’s creditworthiness.

Should I Sign a Personal Guarantee?

The decision to sign a personal guarantee necessitates thorough consideration:

Risk assessment. Evaluate the impact on personal assets and financial stability if the business defaults on the loan.

Negotiating terms. Try to limit liability by negotiating the extent of the guarantee or exploring alternative arrangements.

Legal counsel. Seek legal advice and financial experts to comprehend the terms, risks, and potential consequences of the personal guarantee.

Exploring alternatives. Research alternative business credit options that might not necessitate personal guarantees.

The Bottom Line

Personal guarantees play an important role in small business financing. For lenders, they provide an added layer of security. For borrowers, they can help improve the chances of approval when applying for a business loan. Because they put the guarantor’s personal finances at risk in the event of default, borrowers should be careful to understand their terms before signing.