By Colleen S. Krcelich, CPA | Werner & Co.
For many people, owning their own business is part of the American dream. However, a new business may require significant funding to get off the ground. While the majority of entrepreneurs rely on personal savings to start their new business, some may not have enough available.
A trip to the local bank to secure financing may be required. Banks will require a loan to be secured by business assets, including owned office equipment, computers, vehicles, and machinery. In addition, when a business owner applies for a business loan, the bank may require a personal guarantee of repayment should the business close or default on the loan. This is often required from the business owner or other key individuals involved in the business because a bank or other lending institution cannot assess the credit worthiness of a new business, because it does not have any credit established.
A personal guarantee is unsecured, meaning it is not tied to any specific assets of the owner, such as personal savings, a car, or a house. Still, when a business owner signs a personal guarantee, he or she is putting their own personal finances and assets at risk. The bank may also require a spouse to sign a personal guarantee. If the business fails to pay, the bank will look to the guarantor and his or her personal assets. A new business owner must evaluate if they can absorb this risk, as it involves both the owner and their family. Usually, an owner who signs a personal guarantee can be held responsible for more than the loan balance. Other fees may include unpaid interest, legal fees, and collection costs, which can substantially add to the overall balance.
A partner in a business must be especially cautious when signing a personal guarantee. It is likely that, in the event of a loan default by the business, each partner could be personally liable for 100 percent of the debt, even if they only own 25 percent of the business. If you are not an active partner in the business, you generally should not be offering a personal guarantee since you usually do not have any say in how the business is managed on a day-to-day basis. If you have no ownership in a business, and are instead just an employee or manager of a business, you should never offer a personal guarantee.
It is common for a bank to require a personal guarantee, and it should not scare off a new business owner. It may be the only way the business can secure the funding it needs to fuel its growth and expansion. If you have to sign a personal guarantee, it is always wise to have a lawyer and your CPA review the loan documents and personal guarantee documents. They will provide sound advice and warn you of any potential pitfalls.