Most lenders require the individual owner of a small business to personally guarantee loans made to a business. This pledge indicates the owners' 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:
1. Attempt to limit the length of the guarantee in time, or the amount that you are personally responsible for. Try to recover your personal guarantee as soon as the business can carry the debt on its own.
2. Limit the amount of 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, certain securities or funds. Consider pledging the cash value of life insurance as an alternative for other collateral. This is an asset you may not miss as much as others while it is tied up as collateral for a loan.
5. Limit 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:
So while personal guarantees are usually required, you may be able to minimize the impact.
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 firm's real estate. In addition, the lender demanded that all other company 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 would 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.