ROI, or return on investment, is a term that you may hear often. However, many have never considered it in terms of a personal guarantee (PG). Yet, if you think about it, giving a guarantee on a loan is an investment of sorts. According to Dictionary.com, the definition of investment is “the action or process of investing money for profit or material result.”
With a personal guarantee, you are putting your assets on the line as a way to get funding for your business in hopes of helping it survive and thrive. Since your guarantee is an investment in your business, and all investment involves risk, the question then becomes how do you minimize risk and increase ROI.
Why Take the Risk at All?
When small business owners are looking for a business loan, often banks will ask for personal guarantees. In particular, when a business does not have an extensive credit history, a lender’s risk is higher. As a result, the lender will require a guarantee to mitigate their own risk.
However, no company owner can give a guarantee for everything. It’s not practical. All of your personal credit would be tied up. Your personal credit score could plummet. You have to find the balance between when it is worth it to give a guarantee and when you should pursue another option. Understanding the potential return on investment (ROI) for your PG is vital to knowing if it is worth it, or not.
What Makes the Risk Worth It?
There are a few things that make the investment of a PG worth the risk. The first is, if you need immediate funding for your company and you cannot get it any other way. If it’s a choice between giving a guarantee or not getting the funds you need, it may be worth it to give a guarantee.
That is, assuming that the chances are high that the funds you get will have the desired effect of helping your business grow and thrive. Then it will be a good ROI on your personal guarantee.
It may also be worth it if the guarantee will significantly decrease the interest rate on the loan. Decreasing interest expense means you get the funds at a lower cost, which results in a higher ROI.
When are Personal Guarantees Not Worth It?
For business owners, it has to all be about value. Lenders will take a personal guarantee every chance they can get. Yet, it puts an owner’s personal assets on the line. In small business lending, this means lenders can legally claim whatever is pledged to secure the loan agreement. Consequently, you have to determine if the ROI on your guarantee is worth the potential cost.
If your business fails, then your personal assets will go to the lender. Unless your personal finances are infinite, you probably don’t have a lot of assets that are sufficient for a PG.
After real property, what other assets do you really have? Investments might work. But then, of course, you can lose them if your business defaults. If a small business owner is relying on a certain asset for something specific, like retirement financing, it could spell disaster. The risk, for a lot of owners, is too great. You could lose it all. That is not an acceptable ROI.
However, if you feel that the funds will help you to grow your business substantially and the risk to your personal assets is low, you may have an ROI that is acceptable to you.
What are the Risks of Defaulting on a Business Loan?
For newer businesses, the chance of failure is about 20% in the first year. It’s about a 50-50 chance a business will survive to see its fifth year.
This is why small business loans are a big risk for lenders. A lender asks for a personal guarantee to give the owners a greater stake in the company’s success. When a small business loan could cost an owner his or her future, then there’s more incentive to work toward company success.
That is where the ROI for the lender comes in. They get the loan funds back plus interest. But what about the owner? What owner isn’t going to work for business success regardless, whether their personal assets are on the line or not?
As an owner of a business, you have to know when it is necessary to give a guarantee. Then, you have to know when there is another choice and how to walk that path.
When do Small Business Owners Have to Provide a Personal Guarantee for a Business Loan?
There are a few times when a company owner has no option but to give a guarantee.
SBA loans will always require a personal guarantee for loans over a certain amount. The Small Business Administration requires guarantees even from owners of well-established businesses. Furthermore, it will want them from all business partners.
This is in addition to all the other things the SBA wants to accompany a loan application. They require collateral, a business plan, a business proposal, possibly accounts receivable, and other financial statements.
That’s not to say an SBA loan is bad. There are other factors which make SBA loans worthwhile. Interest rates tend to be lower for one thing. That means the money you get costs less.
That is the definition of ROI on personal guarantees. If you get more money for less cost, and the benefits to your business are worth it, you have an acceptable ROI on your personal guarantee.
Term Loans from Traditional Lenders
Traditional lenders are likely to ask for personal guarantees regardless of whether you are applying for SBA loans or other traditional loans. They want a small business owner to repay any debt, and this is how they hedge that bet. So, for any small business loan you apply for with a traditional lender, you are likely to have to provide a guarantee.
Your goal, as the business owner, is to reduce the number of loans you need that require a guarantee overall. Then, of those that do require one, figure out how to reduce the amount of the guarantee required.
How to Reduce The Necessity for a Guarantee
SBA loans and traditional loans almost always require personal guarantees. So, the first way to reduce the number of guarantees you have to give is to use other types of business credit.
That means vendor credit and business credit cards. To do this in a way that reduces personal guarantees, you have to separate your business from yourself. That requires a Fundable™ Foundation.
A Fundable™ Foundation requires:
- Separate contact information
- An EIN
- A separate, dedicated business bank account
- A professional business website and email address with the same URL
Once you are set up this way, you can apply for vendor credit in the name of your business. Look for the vendors that do not require a guarantee or a credit check for initial credit, and that will report your payments to the business credit reporting agencies.
As payments are reported on more accounts, your business credit score will grow, helping you get approval on even more accounts without a PG.
How Does Business Credit Increase ROI on Your Personal Guarantee?
It’s almost like a domino effect. As you build a stronger business credit score without a PG, you are eligible for more and more accounts without personal guarantees. Eventually, you’ll be able to get a business credit card without a guarantee.
Here’s where things really start working in your favor. Use these accounts as much as possible. Be sure to responsibly repay credit issued to you. Rely on these accounts as much as you can, and you will reduce your need for a loan. In turn, you reduce your need to give a PG. There is an inverse relationship between personal guarantee and the amount of funds you get with it. The more money you can get with less personal guarantee, the higher the ROI.
An Oversimplified Example
Say you apply for a $10,000 business loan. The lender approves it, but you have to put up a guarantee for the entire amount. That means if your business defaults, you are responsible for the whole thing. You have the potential for an excellent ROI if the business doesn’t default, but if you have issues, you could lose $10,000 of your personal funds.
But, consider the same scenario except, due to your strong business credit score, the lender requires a 50% personal guarantee. Your potential ROI on that is much better, because at the most, you would only personally be responsible for $5,000.
As your business credit score goes, the need for a personal guarantee decreases, making your ROI on PG increase.
Is There More Than One Kind of PG?
Usually, we think of an unlimited personal guarantee. However, there are also limited guarantees. A limited guarantee allows a lender to collect a certain amount of money or a certain percentage of the outstanding balance from a principal or business owner. These guarantees are common when there are several principals who can pay a certain fraction of the debt. For instance, if a small business defaults on its loan, the lender can go after each principal for 25% of the balance.
With a limited guarantee, the business owner has some protection. Not all their assets are on the line, which in itself increases borrower ROI. Since lenders can seek repayment from more than one of the owners, there is still value, even if the business fails and does not fully pay the debt. This is another way to increase the ROI on your personal guarantee.
When Can Business Owners Get More Value from Providing a Guarantee?
Sometimes, you need to make investments in equipment or inventory in a short time frame. Or you may want to buy quickly in order to hedge against rapidly rising inflation. In this case, after business owners evaluate risk and costs, they may determine that gambling on personal liability is worth it. That is when you weigh the potential ROI against the guaranteed ROI of nothing if you do not take advantage of the opportunity.
The initial investment may be scary, but it may also be worth it in the long term if it helps your business grow, thrive, and reach its full potential. In the end, business loans are risky on all sides. However, without risk there is no growth. No one starts a business and hopes it never grows. Growth is the first goal. Business growth equals profit growth, which is the ultimate ROI.
Loan agreements that require personal guarantees definitely have the potential to reduce ROI on the business overall. So, it is vital to carefully consider any loan agreement to discern whether it is worth it, or not.
As always, whether or not a PG is necessary is not the only thing to consider. There are also loan fees and legal fees that come into play. Pay attention to those. They can add up.
As with other investments, the ROI on your personal guarantee depends on a number of factors. The key is to protect your own credit history while still giving your company it’s best shot. If an owner needs to personally guarantee funds, that isn’t a bad thing. Yet, it is important for small businesses to balance that with other credit that does not require that personal assets be sacrificed.
This means that the company has to have credit in the name of the business, separate from that of the owner. This business credit will not remove the need for a PG completely, but it can reduce it drastically. It can increase the amount of credit available without a guarantee, and reduce the amount of guarantee necessary for those accounts that still require one.
Another thing business credit can do is help you get lower interest rates on accounts. Since that means the funds cost less, it’s an automatic boost to ROI. Anytime you can get lower interest it’s a good thing.
Balance is key. Find out how to set your business up to get the most possible funding without a personal guarantee with a free Business Finance Assessment.