Legally Speaking: The Personal Guarantee – 5 Ways Small Business Owners Can Reduce Their Liability
There are over half a million small businesses in Arizona employing approximately 45% of all non-public employees. Many in our Arrowhead community are small business owners and know that starting a new business is risky. Loans and leases, particularly with new businesses, frequently require the dreaded “Personal Guarantee”.
A personal guarantee is a legal commitment by a business owner (and their spouse in AZ per our community property status) to repay a debt if the business cannot. These guarantees put personal assets of entrepreneurs on the line. However, there are steps to take to minimize your liability.
1) Request limitations on when the guarantee goes into effect. Try to limit the personal guarantee to only apply once a certain number of payments have been missed or if the net worth of the business decreases below a specific amount.
2) Ask for the amount of the personal guarantee to be decreased over time. Once your business has stabilized and established track record of creditworthiness, the amount of the personal guarantee could be reduced.
3) Seek 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 any individual business
owner, even if there are multiple owners. Try to avoid this “joint and several” liability, which allows the lender to recover the full amount from you if your business partners no longer have sufficient personal assets to cover the loan. If you have a 50% stake in the business, seek to limit your personal liability to 50% of the outstanding debt.
4) 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. Federal and State laws protect your retirement accounts (401k, IRA, Pension, etc.) from creditors, but it does not hurt to state this in the guarantee.
5) Agree to pay a higher interest rate–you may be able to eliminate or limit the need for a personal guarantee by doing so. It is important to evaluate the pros and cons of a higher interest rate, however, as the profits your business generates will be reduced by higher interest payments.
Note: Establishing a business entity that provides limited liability (LLC, Corporation, Limited Partnership) will not protect you from liability under a personal guarantee. It is still critical, however,that you organize your business as one of these liability-limiting entities to preserve personal creditor protection against the debts that are not personally guaranteed.
Conclusion
Lenders are likely to include terms in small business loans providing 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. By negotiating terms that will minimize your liability and maximize protections for your assets (and your credit rating), you will help yourself to…
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