If getting your small business off the ground requires a loan, the lender might ask you to make a personal guarantee. This acts as an insurance policy in the event that you’re not able to pay the loan back. Before signing off on a personal guarantee, you need to know what you’re agreeing to and how you may be impacted financially if you default on the debt.
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Personal Guarantee Explained
A personal guarantee is a legal promise that you make to repay a debt. Personal guarantees are most often associated with small business loans but you may also have to agree to one if you’re a business owner or a freelancer applying for a small business credit card.
When you make a personal guarantee, you’re assuming responsibility for any debts incurred by the business. If you don’t make good on the loan, the lender can come after you personally to recover what’s owed. You could be sued and subsequently have a lien placed against your personal assets, even if the debt is under the business’s name.
Why Lenders Require Personal Guarantees
If you’re taking out a substantial loan to start a new business, the bank’s going to need some kind of assurance that you’ll be able to pay it back. When the business doesn’t have a lot of assets yet or you’re not offering any collateral to back up the loan, a personal guarantee becomes the lender’s ace in the hole against default.
A lender may also ask for a personal guarantee if your personal credit isn’t that great or you haven’t had a chance to establish credit in the business’s name yet. In that scenario, committing to a personal guarantee may be your only option for getting funding.
Related Article: How to Start a Small Business
Business Structure and Debt Liability
The way you set up your business can influence whether you’re personally responsible for the debts you incur. For example, if you’re operating as a sole proprietorship, you and the business are essentially the same for borrowing purposes. The business would affect your personal tax situation. And when taking out a loan, you would be held personally responsible for any debts you incur for the business, regardless of whether a personal guarantee is required.
Establishing your business as a corporation or limited liability company adds an extra layer of protection but only to a certain degree. Generally, your personal assets would be shielded from debt collectors. This rule doesn’t apply, however, if you co-sign a debt in your own name or make a personal guarantee.
Negotiating a Personal Guarantee
If you’re trying to get a loan and the lender isn’t willing to budge on a personal guarantee, it’s in your best interest to try and negotiate the most favorable terms possible. For instance, you can ask the lender to cap the time frame during which the guarantee will be in place. In most cases, a personal guarantee stays in effect for the life of the loan. But you might be able to find a lender who’s willing to let it expire after you’ve made a certain number of payments.
You can also negotiate restrictions on which assets the guarantee applies to. For example, if you own a home you could ask that it be excluded. You could also ask the bank to limit your liability to a certain dollar amount in order to minimize potential losses in case the business doesn’t take off.
Related Article: Pros and Cons of Using a Personal Loan to Fund Your Startup
Agreeing to a personal guarantee involves a certain amount of risk, so it’s important to know what you’re getting into before signing. Short of asking the lender to remove the guarantee, the only way to eliminate it is to file for personal bankruptcy. That’s an important consideration to keep in mind when applying for a business loan.
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