When the bank asks you for a personal guarantee on your small business loan (and it will), here's what you need to know.
Personal guarantees are among the aspects of financing a small business that entrepreneurs love to hate. If you're seeking a small business loan, you might be asked to provide a personal guarantee of the loan, either in full or part. In fact, laying one's own finances on the line is a common expectation today.
A personal guarantee, almost by definition, is unsecured, which means it is an amount not tied to any specific asset such as a residence. By making a guarantee, however, you are are putting yourself - and your assets - on the hook, by acting as the loan's cosigner. If your business dissolves, you will be responsible for repayment. Creditors will go after you in the event that your business fails to repay the loan.
Should you decide to apply for a small business loan, here's what you need to know.
Making a Personal Guarantee: Why Bother?
If you started a business, you could be forgiven for deciding not to bother trying to borrow money from a bank. And you wouldn't be alone. Nearly 80 percent of entrepreneurs rely on personal savings to start their new endeavor, according to Sharon Fullen, author of How to Get the Financing for Your New Small Business.
Compared with other ways to raise money—home equity loans, finding investors, and borrowing from family—applying to a bank for a small business loan can be difficult. That said, it's also one of the least risky ways of ensuring funding.
At least for you.
Conversely, for banks, small business loans are on the risky side of the spectrum. The purpose of the personal guarantee is to mitigate the bank's risk. Moreover, in these days of heightened lending scrutiny spurred by the subprime-mortgage crisis, small business owners are increasingly turning to small, local banks or community credit unions rather than the banking behemoths that dominated small-business lending in the past decade.
Entering a financial partnership with a lender in your community can engender a mutually-beneficial relationship. But it also will likely put your venture or business proposal under a microscope. "Community banks' whole niche is to work with small businesspeople, because it's too expensive for the big banks to work with them," Short says. "The small bank has a tremendous incentive to make that work, but they'll need to know whether you have the right capital to get started."
Making a Personal Guarantee: Weighing Risks vs. Benefits
When applying for a small business loan, you appeal to a lender with your business plan, complete with financial statements and revenue projections that look six months into the future; good personal credit; and your ability to sink some initial personal investment into your venture. That's equity, and lenders like to see you pledge between 10 and 20 percent of your company's total equity in personal savings.
You'll also be asked by the bank to fill out a standard loan form, on which the expectation of a personal guarantee will be raised. Before filling it out, first ask yourself: Would it possible for me to follow through on this promise without greatly affecting my personal life?
"If you're going to start a business, you've got to be willing to lose some money," Short says. "But don't lose your entire future, your house and your children's college education by pledging too much."
The second question you should ask yourself is: Is this a worthwhile investment? Remember: this business may be your baby, but it is still a business, and decisions made regarding it need to be level-headed and fiscally sound.
"You have to separate emotion from objectivity," says Chuck Matthews, the executive director of the center for entrepreneurship, education and research at the University of Cincinnati. "The minute you get emotional about it, you're going to make a bad decision."
If doing so seems impossible, Matthews says seeking input from an impartial financial advisor who can raise red flags and identify future risks. In particular, you should be wary of a business plan that shows you will incur large cash deficits in the first few years, from which your business may never be able to recover.
Dig Deeper: What to Expect in a Personal Guarantee
Making a Small Business Guarantee: How Much Should You Risk?
Back to the loan application. When filling it out, you'll encounter several questions about whether you plan to personally guarantee the loan, and by how much. The first is a simple yes/no and amount. You'll also likely be asked about collateral, which is also increasingly a separate requirement. This requirement will vary lender to lender. Before you start filling out the loan application - and certainly before you meet with your lender - you'll want to determine what you can reasonably afford to risk.
In today's lending environment, it is not considered unreasonable to back your own loan 100 percent with a combination of a cash guarantee and collateral, which can come in the form of property, home equity, and other investments, according to an analysis by William C. Deegan, director of the Small Business Development center at Richards College of Business at the University of West Georgia in Carrollton, Georgia.
That said, because there is no golden rule for what percentage of the loan you should guarantee, it's perfectly acceptable to negotiate. Find out what your lender expects by asking him or her what percent of the bank's total small business loan portfolio is guaranteed. Keep in mind that expectations can vary based on many factors, from geography to the sector in which your business operates. Chiefly, the outcome of your loan will depend upon your lender's desire to take a chance on your business - and what percentage chance they are willing to take. That is a two-way street, of course, because putting up a guarantee can strengthen your loan application greatly.
If you're uncomfortable - or unable - to guarantee 100 percent of your small business loan, you might want to consider breaking up the resonsibility among multiple parties, including your business partners, your investors, and even your spouse.
Making a Small Business Guarantee: Who Else Should Be Involved?
Following the lead of the Small Business Administration's standards, it's generally fair to say that any individual with a 20 percent or greater stake in a small business should be part of the loan-gurantee process. Your active business partners should definitely have skin in the game. Investors and other backers might also be willing to provide a guarantee, and banks are not only amenable to that idea, but seem to prefer multiple guarantors. Minimizing your risk by spreading it among multiple parties can be a great option, experts say.
Your lender may also ask your spouse to sign the personal guarantee. If your spouse has a heavy hand in your business, a joint guarantee is worth considering. Make sure your spouse is also highly educated about the risks involved in signing on as a personal guarantor, including future losses and immediate credit ramifications. You should definitely discuss this step with a financial advisor and a lawyer, because intertwining your business's finances with your personal net worth can cause serious difficulty in the event of a divorce or separation.
Making a Small Business Guarantee: Three Things to Watch Out For
• Take into account other responsibilities your bank might tie to the guarantee should the loan default. These can include interest, legal fees and other miscellaneous costs. Take this amount into consideration in addition to the original guarantee amount before signing.
• Carefully read and examine the bank's actual guarantee agreement. If you have a legal counsel or advisor, have them also review it for you.
• If you're considering making a personal guarantee on a business that's not solely your own, think twice – or thrice. Generally, if you aren't the owner or manager of a company, you shouldn't be offering to back it on a standard bank small business loan.
Making a Personal Guarantee: Working with Your Lender
Though you may feel put on the defensive when a lender asks for you to put up a guarantee, it is possible to structure a loan that works for all parties involved.
"Ask yourself: Is it good for my bank, is it good for me, is it good for my business?" Matthews says. "If it's not, you have to look back and say, what's the impact on the losing entity here? Can it still work?"
Remember, your bank both has a lot to gain and to lose by taking a chance on you."We have seen the effects of making loans that do not have proper backing," Matthews says. "It just gets everybody in trouble – not just individuals, not just taxpayers, everybody."
You'll want to give them all the evidence you can to demonstrate that you are likely to succeed. Show them you have a great team working on your project, and powerful ideas at work. The more you persuade them of your business's chances for success, the more room you will have to negotiate on the personal guarantee.
That said, if the bank still wants a guarantee larger than you're prepared to offer, break out an old-school move. Bring a yellow legal pad and be prepared to write down another figure. Bankers can be receptive to a bit of bargaining; after all, if they've gotten this far in the loan process, they have already shown they do want to see you succeed.
Dig Deeper: Answering the Tough Questions Your Lender Might Ask
Making a Personal Guarantee: Additional Resources
How to Get the Financing for Your New Small Business: Innovative Solutions from the Experts Who Do It Every Day, by Sharon Fullen. Atlantic Publishing Company, 2006.
The SBA Loan Book: Get a Small Business Loan - even With Poor Credit, Weak Collateral, and No Experience, by Charles H. Green. Adams Media, 2005.
The Startup Garden, by Tom Ehrenfeld and Jim Collins. McGraw-Hill, 2001.