Aren’t we all ready to tell our boss off, walk out, and start our own company that will be wildly successful? Don’t we all have those great ideas that we know would be successful if only we had more time to dedicate to nurturing it? We see success stories all over the internet and TV about people who dropped out of college or quit their day jobs to pursue their dreams. They’ve been successful and are now raking in the dough, shouldn’t we want that to?
Photo by Peter Kaminsky via Flickr
Entrepreneurship is a great thing no matter where you are, but it is often is over-glamorized and hyped up beyond reality. We see companies going public and businesses taking off, but we don’t see the 20 hour days, the days without any cash or sleep, and the years of dedication it took to get there.
One glaring risk that many would-be entrepreneurs miss is that of where to get financing to start or run their business. We think it is as easy as going to the bank with a well designed business plan and they’ll hand us a check without any questions. That is simply not accurate. Most banks will not lend money to new companies without some form of guarantee to incentivize them to take the risk. That’s where one of the harshest realities of starting your own company comes in: the personal guarantee.
What is a Personal Guarantee?
A personal guarantee is where the owner of a start up or established and expanding business offers to personally guarantee part or all of the loan the bank provides to the business. This guarantee makes the owner personally liable if the business defaults on the loan.
Banks require personal guarantees for loans going to companies that are either new, do not have established credit histories, or are expanding operations significantly.
Is a Personal Guarantee Really a Big Problem for Entrepreneurs?
For the owner of a small business or entrepreneur that is trying to secure funding to get off of the ground. It is a necessary evil for many companies to extend their operations. Sometimes a bank loan with a personal guarantee is the only way to secure funding.
However, this is a seriously risky proposition for the owner of the company and will lead to serious conversations on how to proceed with close confidants or the board of directors. Even the most confident entrepreneur knows that things can go wrong. Industries change, companies disappear. And if you have employees working for you all it takes is one mistake outside of your decision making that leads to the company getting sued to bring everything crashing down. If that happens the bank doesn’t care how the business died; they just want to get paid back. The whole loan lands on the entrepreneur’s shoulders (and assets).
How Bad Can Business Loan Personal Guarantees Be?
Imagine a business that is doing $500,000 per year in revenue every year. They’ve been around for two years and have hired enough employees just to keep things going smoothly. They’ve got 5 major customers, all who love the service and want to continue buying from the business for the years to come. New customers are being referred to the company on a monthly basis from happy existing customers, but the current staff is stretched thin already.
The owner of the company decides to double the size of the staff and open a new office on the other side of town. He estimates he will need $500,000 in capital from the bank to complete the expansion. The bank agrees to lend him the money, but only if he will personally guarantee the $500,000 loan. His company is too young to stand on its own credit history.
He begrudgingly signs the agreement and begins expansion. Six months later everything is running smoothly and he’s spent all of the money. His investment is beginning to pay off to the tune of $50,000 in added revenue every month.
But suddenly two of his biggest customers slow down operations or go out of business. His revenues drop significantly and he needs to scramble to find new customers to keep from going into the red. Unable to secure new funding, the business slowly dies off, stuck in an unprofitable cycle it cannot climb out of. The business is only able to pay back $250,000 of the loan to the bank.
In this situation the owner not only loses his personal income from the business, he loses everything if he cannot write a check for the remaining loan balance. His home will be foreclosed on and his cars taken by the bank to repay as much of the loan as possible. Even if he was able to work out a payment plan to pay it back, he doesn’t currently have an income to be able to do so.
This situation is a perfect example of how risky a personal guarantee can be.
How to Avoid Personal Guarantees on Business Loans
There are two ways to fund a business: through debt (loans from the bank that must be guaranteed and paid back) and through equity (selling a share of the business to someone else). There are many schools of thought on how to balance the two. There can be tax advantages for writing off interest. On the other hand you don’t have to personally guarantee shares of the business. If the business tanks the equity investors are simply out of their investment.
If you are looking to avoid personal guarantees the only real option you have is to take on investors. These investors will dissect your business and give you capital to expand operations in the hopes that in the future they will be able to sell the shares for a healthy profit. Taking on investors can be a costly proposition: if you end up selling the business in the future, you won’t get 100% of the sales price. The money will be split up between you and any investors you brought on board.
In a perfect world you the personal guarantee is meaningless if you are successful. If the idea works out, you don’t have to worry about the debt landing on you personal balance sheet. But that is a big IF. Bringing on investors can help you avoid taking on significant amounts of debt while also getting different perspectives on your business practices.
A second way to avoid a personal guarantee would be to use business credit cards to float your operations. However, a business credit card is almost always based on the owner’s credit — not the business’ credit — and that means you are still personally liable for the money borrowed on the card. Plus, you won’t find many credit cards that will give you a $500,000 line of credit to expand operations.
Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He’s building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, and many others.
For a new venture, you’ll either need to take a discount on sales of equity or pay a premium on debt. Pick your poison!Of course the venture capital system was devastated by the housing bubble (why invest in a risky venture if you can earn a 20% annual return in rental condos!?) and now people are hoarding cash and treasuries (yay monopoly money).
Good post. More people should be careful on these. But one thing is that many small banks can’t afford to truly enforce personal guarantees. Especially in down economies. So if you need to sign one, it may pay to investigate if your bank enforces them or not.
Gone are the days when a handshake was sufficient to seal a contract. It is sad that a man’s personal guarantee is not trustworthy.
I am thinking that an investor will want to collateralize every last thing on advancing a loan so that the borrower can not move or breathe without the lender’s approval. This will prove to stifle a lot of small business startups.