If you're approaching a bank for a small-business loan, you'll likely be asked to sign a personal guarantee, making you personally responsible for your business debt. Banks want to know you're serious about paying back your loans— and that you've thought them through carefully.
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"Business lending can either be a tourniquet or a transfusion," says Mary Goodman, CEO of Bottom Line Up Enterprises, a Phoeniz, Ariz.-based consulting firm for small and mid-sized firms. "The tourniquet stops the bleeding short term... whereas a transfusion really brings in new life. Make sure, whether there's a personal guarantee or not, that you're borrowing for the right reasons."
If you are asked to make a personal guarantee on that much-coveted business loan, consider these tips to help protect yourself and your business.
No. 1: Know the risks, then try to limit them.
Depending on your wealth, you may have more negotiating power than you think in determining what you'll risk in the personal guarantee.
"For example, you may say, 'I'm willing to put up my stocks and bonds, but I don't want to put up my house,'" says Bob Mulé, an attorney who represents entrepreneurs with the Hartford, Conn.-based law firm Reid and Riege, P.C.
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Of course, banks usually want you to list your home first because it offers the most leverage. And this can become especially cumbersome for couples.
"Often homes are owned by a husband and wife, so then you have to bring the spouse into your business to agree that the house is going to be at risk," Mulé says.
No. 2: For business partners, a new meaning to "one for all."
Most personal guarantees require what's called 'joint and several liability,' which means each person who signs the guarantee can be held responsible for the entire loan. So even if you own, say, 25% of the business, you could still be personally liable for 100% of the loan.
"If there's a wealthy guy in the deal, the bank has the right in that situation to say, 'We're not going to waste our time on your partners, we're just going to sue you because we know you have a big bank account,'" Mulé says.
To protect each partner in this potential scenario, Mulé says partners should sign their own agreement that "if the bank picks one partner to pay the debt, the other business owners will make that person whole and not leave him high and dry."
No. 3: Beware the 'clause' & effect
Watch out for clauses buried in the document that can trigger unexpected changes, Goodman says. Take the interest rate of the loan, for example.
"Look at under what circumstances the interest rate you're charged with could change, and if there are any external factors [that affect whether] the bank could change rates or terms," Goodman says.
For example, say your line of credit is tied to the prime rate plus a few additional percent. You may find a clause in the contract that allows the bank to use other factors in determining the rate, and it doesn't necessarily have to be tied to prime. Then, you could end up paying double the interest on a loan that you thought was a pretty good deal. And you didn't even know it.
No. 4: Don't gloss over the fine print. (There's a lot of it.)
No matter how confident you are about paying back the loan, you still need to know exactly what you're risking — and that means reading (and understand) all the fine print. Ask your lawyer to help interpret the legalese, although you don't necessarily need an attorney to negotiate for you.
"When the business owner borrows money from a bank he pays not only for his own lawyer, but he also pays for the bank lawyer," Mulé says. "And having lawyers talk to one another can become a very expensive thing."
What's most important is that you're aware of every string that's attached to the debt "because at the end of the day you don't want to get a surprise if something goes bad," Mulé says.
No. 5: You can't run. You can't hide. So don't.
Bankers don't like surprises either, so if they suddenly learn — but not from you—that your business is on thin ice, they're much less likely to work with you.
"Be as transparent as you can with your bank, in a smart way with the advice of counsel, and keep the bank advised of what you're doing," Mulé says. "If you're in a problem situation, what I have found is if you cooperate in an orderly wind-down of the business the bank will be more likely to not call on a personal guarantee."
Of course, it's all on a case-by-case basis. There's always a risk.
"Entrepreneurs have this bravado and confidence that's energizing, but the best ones know that they need to be prudent, too," Mulé says. "There's a difference between bravado and being foolish."