September 14, 2009

When applying for a bank loan, small-business owners are almost inevitably asked to sign a personal guarantee on the note. It's often a moment of truth both for bankers and borrowers. To bankers, a signature is a measure of extra assurance that the loan will be paid back. For business owners, it may be a psychological test -- are you willing to risk it all for the business?

The practice of requiring a personal guarantee is fairly standard among small-business lenders. To secure a loan guaranteed by the U.S. Small Business Administration, for instance, all partners with ownership of 20% or more are asked to provide one.

Even so, advisers to small businesses often counsel against giving a personal guarantee on a loan.

Wharton management professor Keith Weigelt is among those who warn against them. "When you're personal guaranteeing it, that's a whole new ballgame," says Weigelt.

Why the concern? When you sign a personal guarantee, you're pledging to pay back the loan if the business cannot. This goes for even limited liability companies or even if the business has been dissolved. It's as if you're co-signing a loan.

If your business goes south, you could lose not only your livelihood, but your house, savings and other assets you may have. Some lenders also will require your spouse to sign as well, so even if your house or retirement accounts are in his or her name, they could be at risk, too. Should a loan sour, creditors may chase down your co-signers for payments, straining or even ruining family or business relationships.

"Personal guarantees are very dangerous," says Weigelt.

Do you have a choice? You may be able to avoid signing a personal guarantee by doing the following: 

• put up collateral;
• pay a higher interest rate or extra points on the loan;
• have someone else, such as a spouse, family, friend or business associate, sign instead;
• make a large deposit at the bank or bringing in a sizeable amount of new business to the bank. 

But for most small-business owners who need a loan, avoiding a personal guarantee is easier said than done. The choice usually is: Sign the guarantee or you don't get the loan. It's a trade-off that needs to be considered carefully. View it as a moment of reckoning for your commitment to and confidence in your business.

And if you must sign a personal guarantee, there are still ways to try to limit your risk. Smaller lenders that emphasize relationships, such as community banks, may be more willing to negotiate the terms with you, for example.

Here are six more ways that you may be able to limit your risk with a personal guarantee: 

1. Narrow your guarantee to only a portion of the loan.
2. Negotiate to reduce the guarantee amount when cash flows meet certain levels.
3. Guarantee the loan only in cases of gross negligence or fraud.
4. Have any new partners entering the business sign guarantees to relieve some of your financial liability.
5. Avoid having your spouse sign if your assets can cover the loan amount.
6. Restrict your guarantee to only the current loan, not the future loans of the business.