Loans and lines of credit (or LOCs) are an important step for any business to thrive and grow– it’s just part of doing business. But lenders view loans to small businesses, particularly start-ups, as among the riskiest they make.
Regardless of the type of business, they tend to view small businesses and smart-ups as more likely to fail or default on their loan. In an effort to lessen this perceived risk, lenders frequently require small business owners to sign personal guarantees as a condition for giving the loan.
A personal guarantee is a legal commitment by a business owner to repay a business debt if the business is unable to repay it. These guarantees often put the personal assets of small business owners on the line, such as savings accounts, cars, homes, and other assets.
Even if you have to sign a personal guarantee in order to secure a loan, there are still ways to minimize your liability. Small business attorney Tom Walker from Generations Law Group has 5 tips for owners to reduce their personal liability when taking out a small business loan.
5 Ways to Minimize Your Liability
1. Set some limitations on when the guarantee would be used.
When agreeing on the terms of a personal guarantee, you will often have the option of imposing your own limitations or conditions.
If possible, discuss changing the terms so that the lender can only make use of the guarantee once a certain number of payments have been missed, or if the net worth of the business decreases below a specific amount.
There may be some other metric you can use to measure the risk that their loan won’t be repaid. The point is to set up some guidelines so that the lender can’t take advantage of your agreement unfairly.
2. Request that the amount of the guarantee decreases over time as the business grows.
Another guideline you can establish to reduce your personal liability is to request that the amount of the personal guarantee reduces when your business has stabilized and established a good track record of creditworthiness.
As your credit strength grows, your personal commitment should decrease. Many business owners who put personal guarantees on their loans don’t ask for this limitation, and end up staying at great personal liability even as their business becomes more stabilized in the eyes of the loaning institution.
3. Request to get a limited personal guarantee based on ownership percentage.
Unless you negotiate other terms, lenders are likely to try to establish 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.
This provision is known as “joint and several” liability, and it allows the lender to recover the full amount from you if the other owners no longer have sufficient personal assets to cover the loan. Joint and several liability 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.
It’s important to avoid a joint and several provision if you want to limit your personal liability. When you are negotiating the terms of the personal guarantee, establish that each owner is responsible for their portion of the loan based on their percentage of the business.
4. Ask for certain assets to be excluded from the personal guarantee.
In general, the financial institution you’re borrowing from would love to have every asset you own included in the personal guarantee, such as your home. If possible, it’s important to remove certain assets from the guarantee.
Some states, including Idaho, have “homestead protection statutes” that limit the amount creditors can recover from the sale, or at least exempt primary residences from being sold to meet the demands of most creditors. If your state doesn’t have a homestead law, it’s especially important to specifically name your home, and other essential assets in your agreement, and specify that they’re excluded from the scope of the guarantee.
Keeping these assets separated will give you more peace of mind when adding a personal guarantee to your business, and it will prevent creditors from coming after your home in the future.
5. Agree to pay a higher interest rate and avoid the personal guarantee.
Just because the institution asks for a personal guarantee doesn’t mean they actually need one for your business. You may be able to eliminate the need for a personal guarantee, or at least reduce the amount, if you agree to pay a higher than normal interest rate. Do a financial analysis of the situation and see what level of interest rate you could support in the business if you were able to eliminate the need for a personal guarantee.
It’s important to consider the drawbacks of this agreement, however, as the profits your business generates will be reduced by higher interest payments. It would be unfortunate to make a rash business decision and get stuck with a high interest rate too long just to avoid the personal guarantee clause in the loan. The best solution is to get input from your certified public accountant and small business attorney before making this decision.
What to do next
The most important thing you can do to reduce your personal liability in a personal guarantee is to do your homework. Get some outside advice, and put a plan together before approaching a lender about getting a loan.
The second most important thing you can do is to get legal advice from an attorney experienced in small business transactions. The smaller your business is, the more likely lenders are to include terms in your loans providing extensive personal liability. It is essential to seek legal counsel to explore the full ramifications of a personal guarantee before you sign on the dotted line.
Hire a small business attorney in Idaho today
At Generations Law Group, we can help you negotiate terms that will minimize your liability and maximize protections for your assets, and protect your credit rating, while you’re at it. Let’s make sure your risk is as low as it can be while you continue to grow. Contact us today to schedule a consultation.