Your new business needs a capital infusion to get off the ground. The only problem is that a new business is not established enough to have generated a business credit report. It may also be lacking assets that can be used as loan collateral. Without a business credit report or business assets, lenders cannot judge whether your company is a safe bet for a loan. Being stuck in this cycle is a bit like applying for a job that requires previous experience in the field—but the only way to get that experience is to first land a relevant job. If your business does not have the assets or track record needed to secure a loan, a personal guarantee of a business loan may make it easier to borrow money. A loan guarantee, which essentially makes you the cosigner on a business loan, undermines the personal asset protection that you may have been seeking when you set up your business as a corporation or a limited liability company. However, it can be a way to break the frustrating cycle of needing credit to get credit. Before making a personal guarantee on a business loan, you should be confident that the benefits outweigh the risks.
Business Credit Scores
You are no doubt familiar with personal credit scores from credit bureaus like Equifax and TransUnion. These scores range from 300 to 850 and are based on factors such as payment history, amounts owed, credit mix, and length of credit history.
Business credit scores are similar to personal credit scores. Provided by business credit reporting agencies like Dun & Bradstreet and Equifax Small Business, they range from 1 to 100 and are a snapshot of a business’s creditworthiness.
A business credit score reflects the details of a small business credit report. This report affects the amount of credit you can receive, loan repayment terms, interest rates, and other lender decisions. A small business credit report typically includes information about the company’s historical data, governance, operations, employees, payment and collections history, and public filings.
The Loan Request Review Process
Personal savings are the primary source of startup capital for new businesses. You can also obtain startup financing by borrowing from family or friends, taking out a home equity loan, finding investors, or applying for a small business loan from a bank or credit union.
Small business loans come with plenty of red tape. Lenders are understandably careful about extending credit to businesses that do not have a proven track record of success. Lenders view new businesses as high risk. They also make less profit on small loans. Small business bank loans are denied approximately 80 percent of the time.
Business owners should be prepared for an extensive vetting process. If you apply for a loan, the lender will put your venture under a microscope. Your business plan and revenue projections are just a starting point. Expect personal scrutiny as well, including consideration of your personal credit score. In fact, unless you are applying for a Small Business Administration (SBA) loan or a term loan from a bank, the lender may not even consider your business credit score (which, again, may not exist for new businesses).
A lender will not finance 100 percent of your business. Lenders additionally will want to see that you are investing a reasonable percentage of your personal funds in the business. From a lender’s perspective, the more equity you have pledged to the new business, the more skin in the game you have, and the more motivated you are to succeed. To the lender, this makes you a stronger bet.
What Is a Personal Guarantee?
Aside from contributing some money to your business and having your personal credit score reviewed, the lender may expect you to make a personal guarantee.
Loan agreements are contracts between you and the lender describing the mutual promises the two parties owe each other. One of the promises you may be required to make is that, in the event of a default on the business loan, your personal assets can be used to satisfy the debt. This is a personal guarantee.
Personal guarantees take different forms. They could require you (i.e., the guarantor) to pledge personal assets—like your home—as collateral. Some limit the guarantee amount to just a portion of the loan, while others put the guarantor on the hook for the full loan amount, including interest and fees (unlimited guarantee). The lender might even insert a clause that converts a limited personal guarantee to an unlimited guarantee under certain conditions, such as missing a loan payment.
Personal guarantees are standard on business loans, providing a layer of protection for lenders. They are also common with commercial leases. The SBA requires unlimited personal guarantees for their loans.
Weighing Risks versus Benefits of a Personal Guarantee
Owning a business involves making risk-benefit calculations all the time. This may be true from the beginning if you decide to sign a personal guarantee as part of a loan agreement.
The following are some of the benefits of a personal guarantee:
- It can make it easier to secure a loan.
- You could get a better interest rate on the loan.
- You could receive more favorable repayment terms.
- It can be used in place of business collateral if you are lacking business assets.
These benefits, though, do not come without risks. A personal guarantee gives lenders the right to sue you personally for loan repayment. They may be able to go after your bank account and other assets and even garnish your wages. While the lender may not deny your loan if you refuse to sign a personal guarantee, it could make the loan more expensive as a way to manage risk. That may be less daunting than having your personal assets exposed in the event of a loan default. If you sign a personal guarantee, it is important for your business to succeed, since failure could mean personal liability for business debts. Success is never guaranteed, but at the very least, you should have a strong business plan and a solid understanding of future risks. An impartial evaluation of your business plan can help you to take a step back, identify red flags, and have a fiscally sound approach to starting a business.
For help with your business plan, the business loan process, or any other aspect of starting a business, contact our law office and schedule a consultation.