Personal Guarantee for Business Loans- Meaning and Purpose
Small scale businesses, SMEs or start-ups usually face challenges to raise funding for their businesses. Adding a personal guarantee for repayment of business loans could help them to overcome such issues.
A personal guarantee is an agreement between the lending institution and the borrower that specifies the obligation of the borrower to be held solely liable for business loan repayment in the event the business entity defaults or goes bankrupt. The primary purpose of personal guarantee on business loan repayments is to enhance security for loans to be approved by the lender.
While certain lenders may seek the entire loan amount to be covered under personal guarantee, some others may request for up to 20% of the business loan amount. Moreover, where the business loan is a considerable amount, the lender may request more than one guarantor on the loan.
How Does a Personal Guarantee Work?
The process of entering into a loan agreement includes signing a personal guarantee clause between the parties. Such personal guarantee needs to be agreed in writing by the business owner/promoter/director or any other person possessing substantial stake in the business.
Such commitment will make them liable to repay the business debt in the event of business failure or insolvency even where the bank has already seized the collateral. Still, if the guarantor refuses to honor his debt commitment, the lender can enforce his right to bring legal action against such person and recover pending dues.
Personal Guarantee – Importance and Alternatives
Types of Personal Guarantee for Business Loans
Limited Personal Guarantee
Limited personal guarantee entails those agreements where the guarantor guarantees repayment of a portion of the business loan which is clearly specified in the loan agreement. Normally, in case of a limited personal guarantee arrangement two or more partners/promoters/directors agree to act as personal guarantors for debt repayment. The debt can be structured as either proportional or fixed. In the previous case each partner commits a certain percentage of the guarantee, whereas in the later, the amount of guarantee is fixed to a certain amount.
Joint and Several Guarantees
This is used when multiple guarantors are involved. Each party commits for only a definite portion of the loan which allows risk sharing between parties as per their tolerance. For instance, there are ‘Several Guarantees’ each guarantor has a fixed percentage of obligation towards the debt repayment with no confusion regarding the amount required to be contributed in the event of default. Whereas, in case of a ‘Joint and Several Guarantee’, the lender has the right to pursue the whole amount from any one of the guarantors.
Unlimited Personal Guarantee
Unlimited Personal Guarantees entail transactions where the business owner or any other guarantor is obligated to fully repay the debt in the event of repayment default. As the name implies, unlimited personal guarantees provide the lender the right to use all means to recover all pending dues out of personal assets of the guarantor to recover interests as well as other legal costs.
Typically, businesses owned and managed by a single individual are required by lenders to sign an unlimited personal guarantee agreement. Further, lenders extending loans to high-risk industry businesses or approving substantial sums may seek unlimited personal guarantees.
Continuing Personal Guarantee
This type of personal guarantee remains valid unless revoked in writing. It is particularly used in case of revolving credits.
Springing Guarantee or Bad Boy Guarantee
This type of personal guarantee is only triggered in case of certain events, usually bad conduct by the borrower, like fraud, misrepresentation etc.
Benefits of Personal Guarantee for Business Loans
Easier Access to Credit-
The primary advantage of a personal guarantee is that it allows easier access to credit facilities which would be inaccessible due to low credit score and lack of creditworthiness of the borrower. Such access to funds would be valuable to promote research and product development, both of which are critical for growth of small and medium businesses.
Assurance of Repayment-
Personal Guarantee from Business owner/Promoters/Directors assure full repayment of debt even in the event the business ceases to exist and cannot repay out of its assets. The lender can seek repayment by compelling the business owner to repay loans by selling their personal assets.
Helps to Build Credit Score-
Business loans, particularly for partnerships, private corporations, and sole proprietorships, can have a huge impact on the company’s credit score. With personal guarantees business loans could help businesses to establish a good credit history, secure better credit terms and growth prospects down the road by exhibiting responsible borrowing and timely repayment.
Collateral Alternative-
Personal Guarantee can be used as a substitute to securing business property to businesses with little or no assets.
Ability to Negotiate Better Loan Terms-
Strong personal credit histories give businesses the ability to bargain for better lending terms, i.e. extended payment duration, cheaper rate of interest, or more flexible payment schedules.
Drawbacks of Personal Guarantee on Business Loans
Potential Risk of Losing Personal Assets-
Personal Guarantee arrangement carries substantial risk for the guarantor as the survival of his personal assets is dependent on the financial performance of the business. In such circumstances, corporate risks can affect personal lives and cause a great deal of stress both emotionally and financially.
Impact on Credit Score-
The credit score of the business owner might be severely affected due to the default on loan repayments. As a result, it becomes more difficult to obtain future funding for both personal as well as business purposes.
Complications in Business Partnerships-
Limited personal guarantees could create trust issues among partners which may impact business functions. For instance, in the event of default if any one party fails to hold his end of the bargain, it may create trust issues or raise legal disputes between partners.
Difficulty in Future Business Ventures-
Where a business owner has a history of default on loan repayments, it is likely to impact his ability to raise funds in the future. Such records could be perceived as indicators of risk by lenders potentially discouraging future entrepreneurial endeavours.
Legal and Professional Costs-
Business owners are likely to incur higher professional and legal fees as a consequence of loan default with personal guarantee arrangements. Also, it might be too expensive to negotiate with creditors or go through lengthy legal proceedings.
Opportunity Costs-
Since assets available for other uses are tied up by personal guarantees, restriction may limit the owner’s capability to fund future endeavours.
Alternatives to Personal Guaranteed Business Loans
Invoice financing / Invoice factoring
Invoice finance is a type of financing facility in which outstanding client invoices act as a collateral for repayment security. Likewise, invoice factoring entails selling unpaid client invoices to a third party who then pursues payment from the client at the end of the due period. These financing methods are more focused on the creditworthiness of the client/customer and generally do not require assurance of repayment through personal guarantee.
Government Backed Collateral Free Loans for Businesses
The Government of India has launched several initiatives which offer business loans without the requirement of collateral while others offer partial guarantee of repayment in the event of business failure. Some of the notable initiatives include the Pradhan Mantri Mudra Yojna (PMMY), the Start-up India Scheme, the Stand-Up India Scheme, etc.
Merchant Cash Advances
Another financing facility that does not particularly require personal guarantee includes Merchant Cash Advance (MCAs). Merchant Cash Advances allow lenders to extend an upfront lump sum amount to the borrower and later collect the amount as a certain percentage of the merchant’s prospective credit/debit card sales for repayment. Rather than seeking monthly repayments, MCAs offer flexible repayment schedules on the basis of the sales cycle of the borrower business.
Equipment Based Financing
Equipment financing is a method of financing that allows businesses to purchase equipment without having to make any hefty upfront payment. The equipment is either loaned or leased for a predetermined amount of time or is utilized as collateral for security purposes. Since the equipment itself acts as a collateral, lenders do not normally require personal guarantees from borrowers.
Revenue Based Financing
Revenue Based Financing is a means of financing under which an investor invests funds in a business with the expectation of earning higher returns on investments apart from a share in business profits until the amount is repaid. It is not the same as equity investment that gives investors business ownership in exchange for investment. This kind of financing allows businesses to utilize their regular earnings as security, possibly avoiding the requirement of personal guarantee.
Points to Note Before Undertaking Personal Guarantee to Reduce Risk.
Comprehend the Terms of the Personal Guarantee-
Comprehend necessary terms in relation to personal guarantee arrangement such as-
- Wherever possible, try signing only a limited personal guarantee for a certain percentage of the total debt to minimize the risk of losing personal assets.
- Steer clear of ‘Continuing Guarantees’ as it could increase the business owner’s exposure for any future loans with the same lenders.
- Keep in mind that in case the Personal Guarantee has been stated as ‘Joint and Several’, any individual personal guarantor could be obligated to repay the entire debt.
Appraise the Financial Risks-
Business owners should carefully assess the potential impact on their personal assets in the event of failure of the business. Additionally, failure to repay loans could severely impact the credit score of the business owner reducing chances to secure funds in future. At the same time, borrowers should also keep in mind that being personally liable for repayment shall also put strain in their ability to manage their other commitments.
Assess Business’s Ability to Repay-
Business owners should make careful assessment of their business plans demonstrating their ability to fulfil debt obligations within time. It is also necessary to consider that apart from timely payments, there may be other terms that might lead to default in the loan agreement.
Explore Alternatives to Personal Guarantees-
Rather than simply considering personal guarantee for business loans as the last resort, business owners should also look for alternatives. For instance, businesses might consider adding collateral to secure repayment or choose other financing methods which do not require personal guarantee i.e. invoice financing, equity financing, etc.
Seek Professional Advice-
Before making any decision, it would be a wise idea to consult an attorney to comprehend all the terms related to Personal Guarantee. Similarly, approaching a financial expert to understand whether or not the loan is a good business investment could save the business owner from going through all the trouble.
Negotiate the Terms of the Guarantee-
Finally, once the business owner finally decides to sign a personal guarantee for business loan repayment, he shall strive to seek favourable terms such as lower interest rates and longer repayment tenure for addition of a personal repayment guarantee clause to the loan agreement.
Conclusion
Therefore, personal guarantees on business loans are intended to minimize risk of lending to businesses not meeting the conventional eligibility criteria for loan approvals. At the same time, business owners agreeing to be personally liable for repayment of entire debt also take significant risk of losing their personal assets in case of business failure. Thus, the decision as to whether to enter into such an arrangement shall be made cautiously by weighing in the benefits and risks of undertaking personal guarantee on business loans. It is also advisable to take help of experts like BankKeeping to avail more credit from same bank and even to help reduce your overall borrowing cost.
FAQs
Is it necessary to give personal guarantee for all types of business loan?
No, in the case of well established businesses, others that can give collateral or ones with a good credit score may not have to give personal guarantees.
What will happen if multiple owners give personal guarantees?
In case multiple owners are involved, the terms of the contract will define the liability of each participant business owner. In case of joint and several guarantees – the lender can hold any or all of the guarantors responsible for the payment. Whereas in case of limited guarantee, each owner is liable to pay only their proportionate share as agreed upon in the terms of the contract.
How does personal guarantee affect the business and personal credit scores?
In case a default is reported by the lender it can negatively impact both the business and personal credit scores of the guarantor. But in case the business has repaid the loan on time, it positively impacts the credit score of the business but the personal credit score of the guarantor remains unaffected.