Personal Guarantees Required in Small Business Loans
Many business owners are more than a little upset when they learn that they are going to be asked to sign an unlimited personal guarantee in order for their business to borrow money. Once they learn some of the reasoning and history behind this requirement, the issue generally settles down. This entry is intended to provide an overall education on the history and reasons a business owner might be required to sign a personal guarantee.
History: After the banking failures of the late 80s and early 90s, Federal and state banking regulators tightened up on banks requiring solid loan documents. This is because many banks during the time were not requiring personal guarantees of their business borrowers. When a business failed, the banks suffered a loss and couldn’t seek recourse against the individual or individuals responsible for owning and managing the business. Certainly most honest business owners don’t intend for their businesses and loans to fail, but during the time there were many wealthy individuals that did not have to repay their company’s bank loans because they had not signed a personal guarantee and they were protected by the corporate veil. As a result, bank regulators adapted a rule requiring banks to require limited or unlimited personal guarantees of any shareholder with over 20% ownership in the company. This 20% ownership rule has more or less been adopted as the standard by private lenders too, even though they are not regulated or required to do so by a regulatory body.
Limited and Unlimited Personal Guarantees: An individual being asked to sign an unlimited personal guarantee is being asked to sign a guarantee that a lender will recover from the guarantor 100% of any outstanding loans made and any and all legal fees associated with the loan. For example, if a business borrowed and subsequently defaulted on a $100,000 loan that cost $10,000 in legal fees to gain a judgment in favor of the lender, someone who had signed an unlimited personal guarantee would be expected to pay back the lender $110,000. If there are several shareholders who have signed such a guarantee, then each one of them are usually held jointly and severally liable. Once a judgment is rendered in favor of the lender, the guarantor’s non-exempt assets can be attached in order to satisfy the judgment. Furthermore the judgment stays on the books in the courthouse until it is satisfied.
A limited personal guarantee is often used when there is more than one shareholder and a shareholder has a smaller interest in the company than the other. The difference is a limited personal guarantee sets a dollar limit that shareholder will be responsible for, instead of making it unlimited. The real effect is that the limited guarantor will always know what the total limit of his financial liability will be if the loan defaults.
Sometimes there are provisions that convert a limited personal guarantee into an unlimited one when borrower fraud is involved.
Fraud is the biggest risk a lender generally faces and an unlimited personal guarantee allows the lender to seek “justice” and repayment of its loan without worrying about how much in legal fees are required to gain a favorable judgment. If the lender is a Federally insured institution, Federal criminal charges may also be filed against a borrower who has committed fraud.
When a small business has no owner with over 20% of shares in the company, one or all shareholders may still be required to sign a personal guarantee; usually all will be required to sign a limited guarantee equal to their percentage of ownership in the company. In some cases, for expediency, a lender will allow (or require) one strong guarantor to sign an unlimited personal guarantee for the company and not ask for guarantees from other shareholders.
Personal guarantee is considered collateral. In any case where a personal guarantee is going to be required, the guarantor is going to be asked to provide a personal financial statement and 2 or 3 years of personal tax returns. The reason the lender will ask for these is because the personal guarantee is part of its total collateral package, so it needs to be able to value the assets of the guarantor and assess their ability to make loan repayment should the company fail to do so. Typical loan covenants require personal guarantors to submit tax returns and an updated personal financial statement at least annually.
There are several types of other personal guarantees including a validity guarantee and a pledge of company stock.
Validity Guarantee: A special kind of guarantee that is used when making working capital loans is called a validity guarantee. This kind of guarantee is used when the small business is owned by individuals or a corporation residing in another country but run by US citizens or persons with permanent resident status. The validity guarantee is signed by the non-owner or less than 20% owner who resides in the US and operates the business on a day to day basis. Essentially it is a guarantee that states that the information submitted on a borrowing base certificate or invoices factored are true and accurate. It holds the signer liable in the case of fraud or misrepresentation, but doesn’t hold the signer liable for other types of losses.
Pledge of Company Stock: Occasionally a lender will require a primary shareholder active in the business to pledge their ownership interest in the company to the lender as part of the collateral required. When a lender asks for this, it is because they want to be able to step in and run a company if the shareholder who has pledged their shares becomes unable or unwilling and the loan is in default. This is most often used by subordinated debt lenders such as Small Business Investment Companies (SBICs).
