Remarkable Truth About Personal Guarantees
As everyone who is even remotely familiar with comic books knows, kryptonite is the one weakness of the otherwise indestructible Superman. In Superman: The Movie, criminal genius Lex Luthor and his bumbling gang used it and nearly defeated Superman. The personal guarantee is a business owner’s kryptonite. It weakens and exposes you and your personal assets to much greater financial risk. At some point in your business life, you’re going to be forced to sign a guarantee. That does not mean you have to accept them.
In this two-part series for the small business owner, we’ll examine what a personal guarantee is and why its such a risk for your business. In part two, Proven Ways to Avoid Personal Guarantees, I’ll share proven techniques for minimizing or even avoiding personal guarantees.
What is a Personal Guarantee?
A personal guarantee (guaranty and guarantee are synonymous) is a legally binding promise that a person, for example a business owner, will fulfill the financial responsibilities of another, such as the owner’s business. In many types of business transactions, a personal guarantee is a customary and typical contract term. You should not be offended if you are asked to sign one. It’s not a personal comment on you or the quality of your business. That being said, you should try and avoid signing it if possible.
Examples of Personal Guarantees for Business
Personal Guarantees are most frequently used by lenders or other types of creditors. Many lenders require small business owners to sign a personal guarantee as additional assurance of loan repayment. If you’ve ever had a loan underwritten by the U.S. Small Business Administration (SBA), you’ve signed a personal guarantee. As a result, the small business owner, in addition to the business itself, is responsible to pay the debt. Similarly, many suppliers or vendors require a personal guarantee before providing goods on credit. For instance, a supplier may require a construction company’s owner to sign a personal guarantee that the owner will be personally responsible for paying the supplier back if the owner’s company fails to do so. Personal guarantees are also very common in commercial leases and equipment leases (e.g. the office copier, a point-of-sale system).
If a business has multiple owners, most or even all of them, even minority owners, may be asked to sign a personal guarantee for a business transaction. If you are a non-operating (i.e. “silent”) partner in a business, by signing a personal guarantee, you may end up with more “skin in the game” than you originally anticipated.
What are the Risks of a Personal Guarantee?
A personal guarantee makes the guarantor personally liable for the obligations of the business. The guarantor’s personal assets are potentially at risk. Most business owners want to avoid exposing their personal assets to business risks. A personal guarantee is the enemy to the business owner’s risk mitigation goals.
As a guarantor, you are liable for a business debt to the same extent as the business. In the event the business defaults on the loan or contract, the obligee can seek payment from the business or the guarantor any in order favored buy the obligee. Thus the guarantor can be sued before the business is sued or, as is almost always the case, the business and guarantor are sued at the very same time. Being named as a defendant in any lawsuit can trigger a host of reporting responsibilities for the business owner. You may be required by other loans or contracts to report the fact of the lawsuit. Your failure to report the lawsuit could be considered a default of those other obligations.
A personal guarantee also gives the obligee leverage in negotiations. They know that the guarantor wants to avoid personal liability and will use the threat of a lawsuit against the guarantor to extract favorable terms in negotiations or settlements of dispute claims.
Case Study: Guarantee Gives Supplier Leverage in Dispute with Contractor
I represented a contractor who was dissatisfied with a supplier’s performance on a project. The supplier repeatedly sent the incorrect materials, delayed deliveries and failed to meet commitments. The supplier’s failures caused the entire project to be delayed, forcing my client to give financial concessions to the project owner. As a result, my client withheld a portion of the contractual amount in an effort to negotiate a financial settlement to recover some portion of what he had to pay to the project owner.
My client’s personal guarantee became a big problem in negotiations. My client ordered materials from the supplier on credit and had signed, many years ago, a credit agreement that included a personal guarantee. He did not notice or remember that it was included. The supplier used that personal guarantee as leverage in the negotiations, greatly weakening my client’s bargaining power. We ended up getting far less in concessions from the vendor primarily due to my client’s desire to avoid being dragged into litigation as a personal defendant along with his business.
Personal Guarantee Can Affect Your Personal Credit Score
Whether or not a personal guarantee affects your credit score depends on the situation. Business loans may or may not be reported on your credit history.
If you sign as a personal guarantor for a traditional business loan, the loan itself will be reported on your business’s credit report. Timely payments on that loan will help build your business’s credit history. Missing a payment could cause the business credit score to take a hit.
In these cases, your personal credit isn’t likely to be impacted. However, if the business defaults on the loan and the lender comes to you for payment, your credit history could start to take a hit. If you immediately make a payment to catch up the loan, you may not see any impact to your personal credit. If, however, you don’t pay and the account goes to collections, that’s likely to show up on both your personal and business credit histories.
Other types of business funding, including some small-business lines of credit and credit cards, do get reported on your personal credit. This can be a good thing if payments are made timely and as agreed, as you could get a bump on that for your own credit score. In the meantime, however, it does potentially impact your credit utilization ratio and your debt-to-income ratio. Those can adversely impact your ability to obtain personal loans or make those loans more expensive.
The Unintentional Personal Guarantee
You can unwittingly personally guarantee business debts without ever signing a personal guarantee. One of the main benefits of forming a limited liability business entity (such as a corporation or limited liability company) is shielding your personal assets from business liabilities. The general rule in Pennsylvania is that members of a limited liability company are not personally responsible for the liabilities of the company. The protective effect of that rule can be weakened by the manner in which you conduct your business. Depending on your actions, a creditor of your company could successfully pierce that limited liability protection.
Some business owners expose their personal assets to business risks by doing simple things, including:
Signing contracts without clearly stating that the business is the contracting party;
Signing contracts without clearly stating that you are signing on behalf of your business as its president, managing member or other statement of your authority on behalf of the business;
Paying personal expenses out of business accounts;
Commingling business and personal funds;
Chronically failing to pay creditors but paying yourself instead.
Now you know some of the most important basics about personal guarantees. Next I’ll share proven techniques to limit or even avoid them.
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