The Truth About Personal Guarantees

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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If you’ve ever borrowed money from a bank for business use, you’ve no doubt argued against adding your personal guarantee to the deal. And if you’re like most small business owners, you lost the argument. Business owners, understandably, hate personal guarantees. Lenders, understandably, love them. If you happen to be one of the fortunate few who have managed to keep your personal signature off the dotted line, this year’s loan renewal may bring a new round of negotiations. To prepare for that conversation, here are the realities about personal guarantees.

According to the National Federation of Independent Business, more than 60% of small businesses reported lower sales and profit in 2009 (June ’08 to June ’09). If you’re among that majority and you have an open line of credit or term loan, that may spell trouble when your lender receives your 2009 financial statements. If your business or personal real estate is pledged on the loan, its reduction in value will no doubt enter into the conversation as well.

We talked about how to approach your banker in 2010 in an earlier post, but only briefly touched on the guarantee issue. The fact is, most small-business owners — particularly those with under $10 million in annual revenue — personally guarantee company debt, and they pledge personal real estate as collateral. Many credit card companies even require personal guarantees on business cards.

Guarantees are required whether you’re organized as a sole proprietorship, partnership, or corporation. If there are multiple owners in the business, each will be required to sign (parties with less than 5% ownership are sometimes exempt). And regardless of your sex, race, color, or charisma, your spouse will have to sign as well. (To the letter of the law, the bank can’t force your spouse to sign a guarantee, but the reality is that if they don’t, you won’t get the money.)

Why are banks so hard-headed about personal guarantees? Because in most cases the lender is betting on you more than your business. So, they reason, if you're not confident enough to put your assets on the line, why should they?

So why doesn’t your pal George have to guarantee his business loans? Well, he’s either a long-term customer of the bank with a steady history of profitability, or he has some killer collateral, or, um, he’s lying.

If you’re stuck with a personal guarantee, here are some important things you should be aware of. They’re probably buried in the tiny print of your loan documents:

• “Joint and several” guarantees make each guarantor wholly responsible for the loan (plus interest, penalties, and collection costs). If you’re a 20% owner, you’re still responsible for 100% of the loan not just 20% of it.
• The lender can collect from guarantors in any order they choose. If you happen to have the deepest pockets, guess who will be first on the list?
• They have the right to liquidate collateral in any order they choose. In other words, they can take your house before your business assets if they feel it would be easier to liquidate.
• The collateral you pledge can be applied to all past and future indebtedness regardless of the specific collateral named on those loans (known as “cross-collateralization”).
• Your guarantee may apply to this and any future indebtedness even if you don’t specifically guarantee the future loans.
• The guarantee amount is not fixed at the loan amount; it’s usually unlimited.
• A default on one loan may constitute a default on other loans (known as “cross-default”).
• The lender can obtain judgments on you and your assets without notifying you (known as “confession of judgment”).
• Guarantors are not allowed to take on additional debts or guarantee other loans without the lender’s permission (known as a “negative borrowing clause”).
• If you have to choke down a guarantee this year, try to make it a temporary thing. Get your lender to agree to performance targets that will automatically trigger a release of guarantees when your performance improves, collateral values return, or net worth targets are met. You might also try to negotiate a limited guarantee (by percent or amount) or offer additional collateral instead.

One final piece of advice, if new owners come on board and you don’t want to be the only one with personal assets on the line if things go bad, be sure to have the bank re-document any outstanding loans to include the new owner.