Personal guarantees for business loans are pretty standard regardless of where the credit cycle happens to be. Banks and lenders may contract or loosen credit policies but personal guarantees are usually not negotiable. Still many business owners are more than a little upset when they learn that they are going to be asked to sign an unlimited personal guarantee in order for their business to borrow money. Maybe if they learn some of the reasoning and history behind this requirement, they will settle down. The following is intended to provide an overall education on the history and reasons a business owner might be required to sign a personal or validity guarantee.
After the banking failures of the late 80s and early 90s, Federal and state banking regulators found many banks during the time were not requiring personal guarantees of their business borrowers. When a business failed, the banks suffered a loss and without the personal guarantee couldn’t seek recourse against the individual or individuals responsible for owning and managing the business. Certainly most honest business owners don’t intend for their businesses and loans to fail, but during the time there were many wealthy individuals that did not have to repay their company’s bank loans because they had not signed a personal guarantee and they were protected by the corporate veil. As a result, bank regulators adapted a rule requiring banks to require limited or unlimited personal guarantees of any shareholder with over 20% ownership in the company. This 20% ownership rule has more or less been adopted as the standard by private lenders too, even though they are not regulated or required to do so by a regulatory body
Personal guarantees come in two primary forms – limited and unlimited. An individual being asked to sign an unlimited personal guarantee is being asked to sign a guarantee that a lender will recover from the guarantor 100% of any outstanding loans made and any and all legal fees associated with the loan. If the business fails, the lender can sue the guarantor and seek a judgment in favor of the lender. If there are several shareholders who have signed such a guarantee, then each one of them are usually held jointly and severally liable.
A limited personal guarantee is often used when there is more than one shareholder and a shareholder has a smaller interest in the company than the other. The difference is a limited personal guarantee sets a dollar limit that shareholder will be responsible for, instead of making it unlimited. The real effect is that the limited guarantor will always know what the total limit of his financial liability will be if the loan defaults. Sometimes there are provisions that convert a limited personal guarantee into an unlimited one when borrower fraud is involved.
Fraud is the biggest risk a lender generally faces and an unlimited personal guarantee allows the lender to seek “justice” and repayment of its loan without worrying about how much in legal fees are required to gain a favorable judgment. If the lender is a federally insured institution, Federal criminal charges may also be filed against a borrower who has committed fraud. Also, a personal guarantee can be powerful leverage to ensure the borrower will do all they can to help the lender collect out.
A validity guarantee is a special kind of guarantee used when making asset based loans. This kind of guarantee is used when the small business is owned by many individuals or a corporation. The validity guarantee is signed by an owner or authorized agent who operates the business on a day to day basis. Essentially it is a guarantee that states the information submitted on a borrowing base certificate or factored invoices is true and accurate. It holds the signer liable in the case of fraud or misrepresentation, but doesn’t hold the signer liable for other types of losses.