Most lenders require the owner of a small business to personally guarantee loans made to the company in question. This pledge indicates the owner’s commitment and helps ensure that the loan obligation won’t be abandoned.
The problem: A personal guarantee means your personal assets are available as collateral. It opens an individual — or a husband and wife if they both sign — to personal legal exposure.
Even if it’s difficult to avoid giving a guarantee, the following five steps can help limit exposure:
- Ask the bank whether you can limit the duration of the guarantee. Make a note to recover your personal guarantee as soon as the business can carry the debt on its own.2. Inquire about limiting the guarantee to a dollar amount or loan percentage, rather than allowing it to be unlimited.
3. Refuse to have your spouse guarantee the loan. This limits the assets covered by the guarantee to those solely in your name as the principal — and not your spouse. Assets held in your spouse’s name, such as bank accounts, would be outside of the guarantee.
4. Exclude certain assets from the guarantee — such as a personal residence, or certain securities or funds. Consider pledging the cash value of life insurance as an alternative form of collateral because this is an asset you might not miss as much as others while it’s tied up as loan collateral.
5. Negotiate a clause limiting the guarantee solely to any deficiency the lender may have after it has exhausted all remedies against the borrower.
Here’s an example of why you should proceed with caution:
An entrepreneur applied for a $1 million loan to modernize his operations. The bank agreed, but asked for a second trust on all of the company’s real estate. In addition, the lender demanded that all other business assets be put up as security, and that both the owner and his spouse personally guarantee the note.
If the owner agreed to these terms and needed to borrow additional funds in the future, he’d have been out of luck — and possibly out of business. All of his company and personal assets were tied up to secure the loan. There was no collateral available to obtain additional financing for new opportunities.
With advice from his CPA, the owner balked at the demands and the lender agreed to take only $1.2 million of collateral on the $1 million loan.
Moral of the story: Although personal guarantees are often required of small business owners, you could be able to minimize the impact. Work closely with your CPA when exploring business loans.
