Guarantees in Lending and the Consequences Behind Them
When you applied for a small business loan, you probably focused upon getting the best rates and terms and worried you might not even qualify for a loan. Once approved, the feelings of relief and excitement could be overwhelming.
As you are going over and thoroughly reading your loan agreement, you may encounter a personal guarantee. These are common in small business loan agreements, and no cause for alarm. Before you rush to sign on the dotted line, however, it is important that you fully understand what this guarantee means and how it could impact your future.
Is a Guarantee the Same as Collateral?
Collateral consists of assets pledged to secure a business loan. In the case of an auto loan or mortgage, it would be your vehicle or house. Small business loans can be secured by collateral, whether it is a personal asset of the small business owner or investments owned by the business. No, this collateral is not the same thing as a guarantee.
A guarantee ensures a certain outcome, such a repayment within a specific time. The most common guarantee in small business lending is a personal guarantee, but you could also be asked to sign a validity or performance guarantee.
Many small business lenders require that you sign a personal guarantee with your business loan, particularly if you are not pledging collateral as with unsecured business loans. When you sign a personal guarantee, you agree to be personally liable should the business default. It means that the lender can attempt to recover the monies owed from your personal assets. This helps protect them from default.
Many small business owners structure their business as an LLC or S-Corp in part to protect their personal finances. Under these structures, debtors would not be able to go after personal assets to recoup their losses. However, if you sign a personal guarantee, you are essentially waiving the protection offered by these business structures.
There are three types of personal guarantees which your alternative lender may ask you to sign.
An unlimited personal guarantee means that you are 100% responsible for the loan. If the business stops paying on the loan or misses several payments, the lender can seek recourse from your personal assets. These assets could include your house, your personal retirement accounts, or your child’s college savings fund.
Not only will you have to pay off the loan’s balance and interest, but you could also have to pay fees and the lender’s legal costs.
If your business has several owners, the lender could ask you to sign a limited guarantee. Under a limited guarantee the debt owed is divided between all of the business owners.
With a several limited guarantee, the business debt would be divided between the owners by a predetermined amount. For example, if you had fifty/fifty ownership, the debt would be split equally between you and your partner.
With a joint and several guarantee, each partner has responsibility for a predetermined portion of the debt but could have to take full responsibility if the other partner defaults.
“Bad Boy” Guarantee
A “bad boy” guarantee essentially converts a limited guarantee into an unlimited guarantee if triggered. It will spell out behaviors which trigger the conversion. These could be but are not limited to, committing fraud, failure to pay other expenses which lead to liens against the business, failing to pay taxes, or filing bankruptcy. These guarantees give a lender extra protection.
Confession of Judgement
Often paired with a personal guarantee, a confession of judgment is not a guarantee, per see. It is designed to make it easier for a lender to collect on a personal guarantee, however. If a lender has decided to extend capital to a particularly high-risk borrower, they may pair a confession of judgment with a personal guarantee.
A confession of judgment permits the lender to bypass the court system should a borrower default on their personal guarantee. If you sign it, you waive your right to a trial or hearing, or the ability to defend yourself in court. Should you default on your personal guarantee, the lender only has to file the confession of judgment with the county clerk or agency. They will inform you of a judgment against you.
A confession of judgment is not legal in all fifty states, and in some states is only allowed to be included in commercial lending contracts. Signing one impedes your legal ability to fight collection efforts, and can be triggered by as a little as one missed payment. Whenever possible, try to avoid signing a confession of judgment.
Common in the construction industry with construction business loans, performance guarantees are meant to protect the lender if a contractor fails in the full performance of a contract. They promise that if certain performance milestones are not met, the contractor will pay a sum of money to the lender. In the area of small business loans, they are rarer but could apply if repayment has been linked to performance.
This would be most likely with a merchant cash advance repaid by credit card transactions. You could be asked to guarantee that your sales performance will be sufficient to repay the MCA within a few weeks or months.
If you pledge your invoices to an invoice factoring company, they will likely require that you sign a validity guarantee. When you sign a validity guarantee, you are guaranteeing that the invoices you have pledged are valid, that they have not been promised to another company, and are collectible.
The guarantee also states that if one of your debtors sends payment to you, rather than to the invoice factoring company, you will forward that payment to them. In other words, you assume responsibility for misdirected payments. In some instances, you can avoid signing a personal guarantee and thus tying your assets to customer defaults, if you sign a validity guarantee.
While not technically a guarantee, a UCC-lien flows from the guarantees you have made on your small business loan. A UCC lien, or a lien under the U.S. Uniform Commercial Code, establishes a priority claim on your assets should you file bankruptcy or default on your loan.
When you take out a loan with a guarantee, the lender will draft a UCC financing statement. Once signed, they will file the UCC-lien with your state’s secretary of state. This puts their lien against your assets on the public record. Should you default or file bankruptcy, they will have priority over other debtors.
Not only is a UCC-lien common, it should not give you pause for concern. If you make all payments according to the loan agreement, it will not cause a problem. However, as most lenders prefer to have the first claim on your assets, an outstanding UCC-lien could make it more difficult to obtain additional financing.
When the loan has been repaid, follow up with your lender to make sure that they have filed the termination statement with the state. If liens are not cleared off your record, it could make it harder to access capital in the future.
What are the Consequences of Violating a Guarantee?
The consequences for defaulting on a guarantee vary depending upon the type of guarantee you signed. However, they can be quite serious. With a personal guarantee, little is off-limits should you default on your loan.
Any personal asset can be at risk for foreclosure or repossession. Your home, car, retirement, and bank accounts could all be forfeit. Even if your business is an LLC if you signed a guarantee the LLC will no longer offer the same amount of protection against collection attempts.
If you have a business partner, and you signed limited or bad boy guarantees, you could become responsible for their poor financial management. When going into business with a partner, make sure that you have a good grasp on their financial management skills and ability to handle responsibility. Both will affect your life.
Anytime you sign a legal document, it will have consequences. If you have any questions about guarantees in your business loan, talk to your lender and your lawyer. Reputable lenders are happy to take the time to make sure that you thoroughly understand the commitments you are making when taking out a loan.