A business ordinarily applies for a loan with the intention to pay back. However, not every business performs to expectations at all times. Oftentimes, businesses fail to repay their debts. This is why financial institutions usually seek further comfort for their lending by demanding and obtaining the personal guarantees of the owner(s) of the business.
Lending institutions typically insist on personal guarantees for unsecured business loans that may not be collateralised with the assets of the business.
What is a personal guarantee? What are the features and types of personal guarantees? What should a Small Business Owner look out for should he or she need to issue a personal guarantee in pursuit of a loan application and approval?
A personal guarantee is a legally binding promise by the owner or owners of a business, to be personally liable to repay the debt of a business if the business is unable to do so. Its main purpose is to provide additional protection for the lender in the event that the business fails to repay the debt that is subject matter of the transaction. A personal guarantee gives a creditor a legal claim to any personal assets of the guarantor, inclusive of bank accounts, cars, real estate, and similar liquid assets.
The Small Business Owner is usually required to sign a personal guarantee during the loan application and approval process. And, because he or she is invested in the business and equally eager to secure the loan to enhance the prospects of the business, there is a willingness to issue a personal guarantee. This places the Small Business Owner in the position of a personal guarantor who, when the business is unable to repay the debt, becomes liable to repay the loan granted to the business. This arrangement places the financial resources of the Small Business Owner at risk in case of a default by the business.
The key benefit of a personal guarantee is to mitigate the risk of the lender where the Small Business Owner has valuable personal assets. It enables a small business to access finance which would otherwise be limited to an established business with a long credit ranking.
What are the different types of personal guarantees? Guarantees could be unlimited or limited. They may also be joint and/or several.
In an unlimited personal guarantee, the guarantor agrees to allow the lender to recover the full loan amount, or outstanding balance, plus any other associated costs; like legal cost, cost of collection, etc. The guarantor in an unlimited personal guarantee has no financial protection when the business fails to pay its debt as and when due.
In a limited personal guarantee, a set amount is specified as to what the lender can collect from the guarantor when there is a default on the loan. Limited guarantees are mainly used when business partners jointly or severally guarantee a loan for the business. They define, and limit, each partner’s portion of the debt if the business defaults.
With a several guarantee, each business partner has a determined percentage of liability. Each partner knows his or her maximum exposure from the beginning. It’s usually a known percentage of the loan, and according to the stake in the business.
However, in a joint and several guarantee, each partner/guarantor is potentially liable for the full debt, and the lender can recover the full debt from any one or a number of the guarantors if any of them cannot be found or does not have enough assets to cover his or her portion of the loan. The lender can therefore lien on the assets of one guarantor for his or her stake in the guarantee, plus the remainder portion of what is unpaid by other partners.
The line between unlimited and limited personal guarantee is not always clear. There could be grey areas, hence the Small Business Owner must understand every word of each personal guarantee agreement on its own.
Irrespective of the nature and character of the personal guarantee, always remember that it is a legally binding agreement.
Before putting pen to paper, or electronically signing, on a personal guarantee, take the time to nit-pick the language. Your line of action must be informed by thinking through these four steps:
- Examine your business and personal finances.
- Consider that your business may fail to service its debt and your creditor will have recourse to your personal assets as the last resort in redeeming the loan.
- Understand that the terms and conditions of the personal guarantee could impact your business and personal finances.
- Decide whether the risk is worthy of your signature.
If legal lingo is not your strong armour, you need a professional to help you navigate the terms and conditions of a personal guarantee. Visit the SME Clinic at https://smefinance.org/sme-clinic/