A personal guarantee puts an individual, typically the largest shareholder or principal of the business, on the hook personally for a business loan borrowed by a company. If the business fails to repay its loan, the lender can enforce against the individual and use the individual’s personal assets to satisfy the company’s debt. Essentially, a personal guarantee turns a business loan into a personal liability.
Business owners often jump through hoops to separate their business life from their personal life. They incorporate their business, open separate business bank accounts and use accounting software to separate out business expenses—all to shield themselves from personal liability. That way, if something goes drastically wrong with the business and the company is forced into receivership or even bankruptcy, the business owner’s personal assets are protected and are not impacted by the financial troubles of their company. A personal guarantee prevents this and links an owner’s personal wealth with the performance of the business.
Lenders often require personal guarantees from new companies without an established track record, small companies that may not be able to support outside debt on their own, or companies in a turnaround where the future of the business may be uncertain.
Here are three key reasons that lenders may require a personal guarantee from the shareholder or principal of a business:
Dissymmetry of Information
Despite all the due diligence conducted by the lender, the lender will never know as much about the business, or the intentions of the borrower, as the owner. Is the borrower hiding something that only they could know and that no amount of due diligence would uncover? A lender can demand lots of representations and warranties in its legal documents but it will never be able to fully appreciate all the nuances of the business, including the risks.
You know who you are. You know that you’re a hardworking, honest person with the best intentions to grow your business. As a borrower, you have perfect information, whereas a lender is partially blind. By demanding a personal guarantee, the lender can rely on the assumption that the owner will not want to expose their personal assets to any risk and therefore would not allow their company to take on debt it can not afford to service or repay.
Skin in the Game
A lender might ask why the lender should loan its (or its investors’) hard earned money to a stranger if that stranger doesn’t risk everything they have by putting it all on the line first.
Cooperation in Default
There’s an added level of responsibility required when using someone else’s money to fund your business. A lender needs to know that you’re 100% focused on managing your business and that you’re fully invested in its success. When the going gets tough, it is too easy for someone to just walk away and hand over the proverbial keys to the kingdom.
It’s a classic agency problem. Since it is someone else’s money at risk, what’s keeping the entrepreneur from simply closing up shop instead of fighting to recover from whatever hurdle it is facing? A lender uses the personal guarantee as a tool to ensure the borrower is committed to doing everything they can to revive an ailing business.
In next month’s column I’ll suggest a few ways to avoid giving a personal guarantee.
Steven Uster is the founder of FundThrough, a marketplace lender that provides secured lines of credit for growing companies. He is also the founder of Zillidy, a personal asset lender that lends against precious metals, diamonds, jewelry, watches and other luxury assets as collateral.
Have you been required to provide a personal guarantee by a lender? How did you deal with the request? Let us know using the comments section below.