Small businesses make up a huge part of the U.S. economy. There’s a lot of allure to starting a business but it’s often risky. Lenders view loans to small businesses, particularly start-ups, as among the riskiest they make, particularly when there is little or no credit history or business revenue on which to base their decision.
In an effort to lessen their risk, lenders often require small business owners to sign personal guarantees as a condition for extending the loan. A personal guarantee is a legal commitment by a business owner to repay a business debt with the owner’s individual assets if the business is unable to repay it. These guarantees put the personal assets of small business owners on the line— things like savings accounts, cars, homes, and retirement funds. But there are several steps you can take to minimize your liability.
- Request limitations on when the guarantee goes into effect. Try to include terms allowing the personal guarantee to kick in only after a certain number of payments have been missed or if the value of the business decreases below a specific amount.
- Ask for the amount of the personal guarantee to be decreased over time as the business grows. Once your business has stabilized and established a good track record of creditworthiness, the amount of the personal guarantee could be reduced.
- Seek a limited personal guarantee based on ownership percentage. Unless you negotiate other terms, lenders are likely to want an unlimited personal guarantee. This allows the lender to collect 100% of the loan amount, as well as attorneys’ fees, from an individual business owner, even if there are multiple owners. It is important to avoid this “joint and several” liability, which allows the lender to recover the full amount from you if the other owners no longer have sufficient personal assets to cover the loan. That means that even if you only have a 50% stake in the business, you would be personally liable for the entire amount of the loan. Instead, try to limit your personal liability based on your ownership percentage in the business.
- Ask for certain assets, such as your home or retirement account, to be expressly excluded from the scope of the guarantee. Some states have homestead statutes that exempt primary residences from being sold to meet the demands of most creditors or limit the amount creditors can recover from the sale. Colorado’s homestead exemptions are pretty limited, so you’ll want to try and negotiate this with your lender.
- Consider paying a higher interest rate to limit (or eliminate) the need for a personal guarantee. This option will clearly impact cash flow, so you’ll have to weigh the reduced business profits against the exposure of your personal assets as collateral on the loan.
By the way, establishing a business structure that provides limited liability (for example, an LLC) will not protect you from liability under a personal guarantee.
Lenders are likely to include terms in small business loans that expose business owners to extensive personal liability. It is essential to seek legal counsel to explain the full ramifications of a personal guarantee before you sign on the dotted line. We can help you negotiate terms that will minimize your liability and maximize protections for your assets (and your credit rating). Call us today to set up a meeting.