Reality Check: The Risks of a Personal Guarantee

By the time Sarah Shaw personally guaranteed a second business loan, her company was struggling just to stay afloat. Although the company, Sarah Shaw Handbags, had investor backing in early 2001, it wasn't enough.

"The fashion business is very cyclical and the cash flow is uneven," says the Los Angeles entrepreneur, who did not understand this at the time, relying instead on her business partner who had an MBA. "My accountant kept questioning [my partner's] business plan and I just kept shushing him and saying, 'She knows what she's doing.' What I should have done was not put in any more money.

Instead, Shaw says her naivete ultimately led her to take the second loan for $50,000, secured with her house. Then came 9/11 and its fallout. Investor dollars that were promised now evaporated, forcing the company to shut down and liquidate in 2002. Of course, Shaw was still on the hook for the loans.

"In the end, I only paid off one of the [$50,000] loans and paid my outstanding creditors," Shaw says. "I didn't want to burn all my bridges, so I ended up paying all my vendors 70 cents on the dollar, which was pretty good instead of going bankrupt."

But eight years later, Shaw is still making monthly payments on the $50,000 bank loan she guaranteed with her home.

"I came from a place of desperation to get that loan and keep the business going and that's just a really bad place to come from," says Shaw, whose handbag company lasted five years. "That's when you make rash decisions."

Especially amid today's tenuous lending climate, some small business owners are finding themselves in a similar situation: desperate for cash and feeling pressured to risk their personal assets in an attempt to stay in business. Banks almost always request a personal guarantee to avoid having a business owner quit in frustration and skirt their financial responsibilities. And while some entrepreneurs are able to successfully use a personally guaranteed loan to grow their business, others have found it was a gamble they would lose.

Take Elizabeth Versace. She filed for personal bankruptcy last year, no longer able to pay off a series of personally guaranteed business loans totaling $130,000. The cash was needed to fill an influx of orders for the then-fast-growing Category Five Outwear, a golf apparel company that Versace owned with two partners. Ultimately, the loans secured in early 2007 were not enough to stay afloat. The Palm Springs, Calif.-based company went under by year's end.

"Absolutely the worst mistake I ever made was signing one of those personal guarantees," says Versace, whose partners had invested cash in the business, while she relied on credit. "When the economy tanked, I couldn't find suitable employment to support myself and the outstanding debt."

Versace ultimately returned to work as a commodities trading advisor, her profession before becoming a business owner. Today, she says her entrepreneurial days are over, but she does have aspirations of running for public office to better protect small business owners.

As for Shaw, she's back running her own business again, this time as Simply Sarah, which sells a patented handbag organizer and accessories. Along with $5,000 of her own cash, Shaw secured $25,000 in financing for her latest venture— but did not sign a personal guarantee. And thanks to the lessons learned from her first bankrupt business, the new company was profitable within 10 months.

Branding herself as the 'Entreprenette,' Shaw also now coaches aspiring entrepreneurs on how to launch their own product-based business.

"Make sure you understand your cash flow, and look at when you need to lay out the money," Shaw suggests. "Your business may be cyclical, and it's a constant money outlay when you're in manufacturing. You have to look at your particular revenue streams and when the money will be coming in. There are so many different factors."

As for personal guarantees, Shaw recommends her start-up clients think long and hard before taking such a personal risk.

"It's just one more thing hanging over your head," Shaw says. "If your business has legs, you just have to keep looking for [other funding sources]. There are going to be people who want to invest in it."