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You’re ready to turn your passion into a profit so much so that you already have a tested and proven business strategy. The next hurdle standing between you and the dream of starting your own business is financing. So when you ask for a small business loan, lenders may require a personal guarantee. But what is a personal guarantee? How will it affect your business? And most of all, should you sign it?
So what is a personal guarantee? Essentially, lenders are asking you to put your personal assets and your consumer credit profile on the line as a guarantee that you'll pay them back.
If you default on the loan, your credit will be negatively affected and the lender may try to collect from your bank account and other personal assets.
With these implications, a personal guarantee is an extra incentive for you to pay promptly and fully.
A personal guarantee (often referred to as “PG”) is often required when your business is young and your company lacks a solid business credit profile and financials.
Because many small businesses fail, lenders want to make sure they have some way to recover the debt if that happens. From their perspective, it minimizes risk.
It’s not unusual, however, for established businesses to also be asked to sign PGs. Traditional lenders, such as banks and credit unions, often include them in their small business loan contracts, and they are required if you get a Small Business Administration (SBA) guaranteed loan.
Any business owner that owns a significant percentage of the business (usually 20% or more) may be required to sign the PG.
Another part of understanding what is a personal guarantee is knowing that the owner’s spouse may also be required to sign it so the lender will be able to collect from joint personal assets if that becomes necessary.
When Should You Sign One?
It’s important to understand what is a personal guarantee before you sign—it means that you are responsible for the debt if your business does not pay it.
You should feel confident that your business can financially handle the debt. If you don't, then it may be a sign you should look for other financing. Business financing can help you grow your business, but it can't save your company from failure.
Be especially careful about signing a personal guarantee if you have a business partner but you don’t have full control of your company’s financials, and you would be personally liable for the entire loan in the event of default.
Business involves risk, but you want to minimize those risks whenever possible.
If you’re currently debating whether you should sign one or not, remember that while personal guarantees are sometimes necessary, they are not ideal.
In the early stages of your business, signing one may be the only option for you to obtain funding.
If you sign one and are worried about your credit, signing a PG does not mean the loan will automatically affect your credit reports or scores.
Most commercial accounts will not appear on your consumer credit reports unless you default.
However, if you sign a personal guarantee, it may result in an inquiry on your credit report because the lender will often check your personal credit.
Inquiries have a small impact on credit scores—usually in the range of 4 to 7 points—and affect your consumer credit scores for one year.
What You Can Do
When you realize the full implications of what is a personal guarantee, you next thought may be ways to avoid them. Most lenders will require your business have at least two of the following:
Some lenders may want to see at least $100,000 in revenues while others will require $1 million or more in annual revenues before extending financing without a PG.
Established Time In Business
Again, lenders may require two years in business, while others may require five or more.
This can include equipment or vehicles.
Strong Business Credit
Lenders like to see strong credit with commercial credit agencies such as Experian, Equifax and Dun & Bradstreet.
Building Business Credit
Understanding what is a personal guarantee will help you realize the importance of building business credit—it can help you secure funding without a PG. Ultimately, that should be your goal.
If you haven’t started to build business credit yet, let’s walk through the first steps you can take.
Got Business Credit?
If you know what is a personal guarantee and you don't feel comfortable signing one, check the credit policy of lenders or vendors before you apply for a loan.
The credit application will usually indicate if one is required; a request for the owner’s Social Security number is a tip-off, as are requests for information about the owner’s personal assets. Read your contract carefully so you’ll understand whether a PG is included.
If you've built a good business credit profile, ask to speak with the credit manager when you apply for funding and request to have the personal guarantee waived. However, before you do, ensure you know your business credit scores are solid.
No Business Credit?
If you haven't begun to build business credit, it's time to start. Get a free account Nav account at Nav.com/wealthfit then consider the steps below.
We cover these steps in detail in my WealthFit course, Credit Secrets for Entrepreneurs.
Set Up A Legal Business Structure
Are you operating as a single proprietor? If so, consider incorporating.
If you do, you'll reduce your liability and risk and lenders will take your business more seriously.
You can build business credit if you operate as a sole proprietorship, but you won’t be able to avoid PGs because any loan you obtain will be in your own name.
Get Vendor Accounts
Open accounts in the name of your business with companies that will report your payment history to commercial credit reporting agencies.
These vendors don’t often check personal credit reports and some do not require PGs.
Apply For A Business Credit Card
A business credit card will help you establish business credit so that you may be able to avoid signing a PG. Most of the major small business credit card issuers report payment activity to the three major commercial credit bureaus. (Here’s a list of which credit cards report to business credit.)
All these issuers do require a personal guarantee, but not all of them report payment information to the owner’s personal credit reports.
People often ask me: “What is a personal guarantee?”. A profitable business and a solid business credit profile is your best bet to ensure you won’t be asked to sign a personal guarantee.
But if you do have to guarantee your business loans in the beginning, it’s not the end of the world. It may be the only way to get the financing you need.
Focus on building a successful business—and a solid business credit profile—so you can move away from personal guarantees in the future.