Applying for a loan can be pretty time-consuming: you have to collect all your financial records and documents, complete application forms, and make sure you have a convincing reason to take out a loan. So the more business partners you have to help you through the process, the better, right?
Sometimes, yes—but not necessarily, especially when there’s a personal guarantee involved. The Small Business Administration (SBA) requires that all business owners with a 20% or more share in their business sign a personal guarantee in order to receive financing from a 7(a) loan, and many other small business lenders follow their example.
A personal guarantee (PG) is a document that you, as a small business owner, will probably need to sign in order to receive a loan from a lender, especially if the loan if otherwise “unsecured” (meaning that you don’t post any specific collateral). This document lowers the lender’s risk—by letting them chase after your personal assets if your business fails or you default on the loan. By “personal assets,” we mean anything of financial value that you own: house, car, retirement fund, your kid’s college fund… All of that will be fair game if you can’t pay the lender back. In other words, signing a personal guarantee is pretty serious business.
In some cases, business owners might feel uncomfortable signing one of these forms. It’s hard—and risky—to put your child’s education or your family home, on the line. In other cases, their personal credit scores might be too low for them to be eligible guarantors. In either of these cases, you can consider changing around your company’s ownership percentages so that the partners hesitant or unable to sign the personal guarantee don’t have to.
Why are these Forms Required?
Why do you need to sign personal guarantees, anyway?
As with most of your other loan application requirements—like collateral, credit checks, and your company’s financials—they’re designed to lessen the lender’s risk. Remember that small business loans are, as loans go, relatively risky for lenders: as Forbes reports, small businesses are less stable than larger corporations and their owners usually have fewer assets to post as collateral. That’s why it can be so difficult to find a bank willing to give you a loan.
The personal guarantee acts as a promise from you that you’ll take on some of the lender’s risk by putting your own finances and assets on the line. It’s a sign of dedication to your business—you’re much more likely to work hard to pay off your loan if the alternative is personal, not just business.
It also gives the lender a specific legal process to recover the money they loaned if your business defaults. Without this contract, it’d be much more difficult for them to make sure they receive their money back.
Personal Guarantees and Personal Credit
By this point, you probably know that applying for small business financing requires you to report your personal credit score. In the case of a loan with a personal guarantee requirement, lenders will check out the credit scores of anyone signing that guarantee—you, your business partners, your grandmother, your dog. (Okay, maybe not those last two.)
But if your own credit score is a stellar 700 yet your partner’s is only 550, and she owns 40% of the company’s equity, that could spell bad news for your loan application.
The relationship between credit scores and personal guarantees works the other way, too. By signing a personal guarantee, you’re tying your business finances to your personal finances. If you default on the loan, it’ll get reported to the credit bureaus and will appear on your personal credit report, drastically lowering your credit score. Luckily, according to personal finance service Mint, as long as you make your loan payments on time, business loans usually won’t show up on your personal credit score.
Not All Personal Guarantees are the Same
Broadly speaking, there are two main types of personal guarantees: limited and unlimited. (This is a bit of an oversimplification, because the line between the two is pretty fuzzy, but it’s helpful to understand the main differences.)
Unlimited Personal Guarantees
Unlimited personal guarantees are riskier for you, as the borrower, and are generally required in situations where the borrower has lower credit or is the only owner of the business. The lender is allowed to take whatever they need from you in order to repay the loan in full, on top of any legal fees they rack up during the process. As a borrower, that’s pretty risky… And offers you no protection in the case that your business fails.
If you have a low credit score, you might have to sign an unlimited personal guarantee in order to receive approval for funding. This will offer the lender the greatest sense of security, but at the cost of your own. If you sign an unlimited personal guarantee, you should be very sure that it wouldn’t be catastrophic for you to follow through on its terms.
Limited Personal Guarantees
Limited personal guarantees are more common for small business loans where more than one person owns at least 20% of the business. These state exactly how much money each owner will be responsible for in the event of a loan default.
- In a several guarantee, the amount for which each owner is liable can be a dollar amount or, more commonly, a percentage, often equivalent to the equity each owner holds. So if one owner has 40% equity and defaults on the loan after signing a several limited guarantee, the lender might seek repayment from the owner’s personal assets for up to 40% of the amount owed.
- A joint and several guarantee is technically a limited personal guarantee, but it’s a little less limited than the several guarantee. Although each owner will be responsible for a predetermined portion of the loan, if one of the owners disappears or can’t pay off his or her portion, the lender is allowed to chase after any of the other owners for the full amount of the loan. In other words, a joint and several guarantee doesn’t offer you protection from your partners, especially if you have the most appealing personal assets.
Occasionally, a limited personal guarantee will have a provision stating that it can be converted to an unlimited personal guarantee in the case of fraud. If you behave badly (which you won’t, of course!), the lender will be able to take whatever steps it can to get its money back without worrying about the legal repercussions of breaking the terms of the original limited personal guarantee.
The More Guarantors, the Better?
Generally speaking, your lender will prefer several personal guarantors to just one. If three people are able and willing to put their personal assets on the line in order to pay off a loan at any cost, the lender will be taking on less risk than if there were only one or two guarantors. Multiple guarantors can also bring more outside income and assets to the table, strengthening the loan application.
But this doesn’t always mean that you can ask a family member or a friend to sign a personal guarantee for your business. Every potential guarantor must own a share of the business, and many lenders have minimum time requirements for how long the guarantor must have owned their share. Some lenders, like the SBA, require a look back period of 6 months. (This means they’ll “look back” at the past 6 months of your business’s history to check up on any change in ownership percentage.) Others will require different methods of proving ownership, like articles of incorporation or tax forms.
Bringing in the Professionals
Personal guarantees are often filled with complicated legal language that can get you in a lot of trouble if you misunderstand it, which could pose a huge risk for you and your family’s future. If you need to sign one of these forms, it’s often worth your money to hire a legal professional to go over the terms with you.
For example, seizing unsold inventory is one way for a lender to repay itself if your business fails, but some personal guarantees will go one step further and require that you convert that inventory to liquid capital first. This means that you might find yourself needing to sell off that inventory even after declaring bankruptcy in order to fulfill the requirements of the personal guarantee. It’s best to be fully aware of any and all possibilities that personal guarantee could lead to.
Are Ownership Percentage Requirements Negotiable?
Rarely—although the requirements do change from lender to lender, which we’ll look at more in a bit. If one partner is a “silent partner,” meaning that he or she has nothing to do with the company’s management or day-to-day operations—he or she only provides capital—lenders might make an exception. Unfortunately, they won’t extend the same favor to a partner who’s involved in the company but whose low credit score prevents them from being able to sign a personal guarantee.
Personal Guarantee Insurance
One option for owners who don’t want to sign a personal guarantee because of the risk is to take out personal guarantee insurance, which can help mitigate your losses if you end up defaulting on your loan. This is an especially good option for business owners with families, whose signature on that personal guarantee could affect their spouses and children. AccountingWEB reports that personal guarantee insurance can cover up to 70% of the business owner’s personal guarantee payment requirement, which can make a huge difference in the amount of damage a personal guarantee can cause.
Changing your Ownership Percentage
If you or one of your business partners is adamant about not signing a personal guarantee, you can work with an accountant and a lawyer to change around the ownership structure in your company. Because personal guarantees are only required of owners with a share above a certain percentage, changing percentages of ownership can make it possible for an owner to avoid signing.
The process for changing the ownership percentage in a company depends on the structure of your business, so we’ll break it down by the 3 most common types of small businesses: S-corporations, C-corporations, and LLCs.
S-corporations & C-corporations
S-corporations, which have a maximum of one hundred shareholders, are a popular setup for small businesses because they avoid the double taxation of C-corporations. C-corporations are entities in themselves, meaning that the corporation itself has to pay taxes, and then the individual owners will have to pay taxes a second time on any dividends they receive. In an S-corporation, the company’s income is passed directly through to its shareholders, so taxes are only paid on the individual level.
- Check in with a tax attorney! They’ll help you clarify exactly how much your company is currently worth and the value of its shares. Changing ownership percentages will also affect your taxes, and the attorney can help guide you through these steps.
- Decide whether you want to buy more shares from the company or from your partners. Buying shares from the company means that your partners will still keep the same number of shares, but their percentage will decrease, because there will be more shares in the shareholder pool. Your number and your percentage will then increase. This kind of transaction will require a stock purchase agreement. Buying shares from your partners means that their number and percentage will both decrease and yours will increase. This requires a stock repurchase agreement.
- You’ll want to officially record this stock percentage transfer. In order to do so, either you or your attorney will cancel your original stock certificate and issue new ones reflecting the updated numbers. Those numbers, as well as the numbers of the certificates, should then be written in the company’s stock ledger.
- File updated incorporation paperwork with your state so that they can officially recognize the new ownership percentages. Don’t skip this step! If your incorporation records aren’t squeaky-clean, a court is allowed to “pierce the corporate veil“ and hold you personally liable for business debt. And remember: some lenders will look into your articles of incorporation as proof of ownership status.
Limited Liability Corporations
If your business is a Limited Liability Corporation (LLC), you’ll need to refer to your LLC operating agreement that you drew up and signed when setting up your business. This agreement will include buy-sell provisions that specify how owners can transfer shares among themselves.
With an LLC, you probably won’t need to file updated paperwork with your state, but that depends on whether or not your original incorporation paperwork included the names and ownership percentages of its partners. If it does, you’ll need to fill out an amendment with the new names and percentages. Read over your operating agreement carefully to make sure all of its provisions still apply, and if not, revise it. Finally, you can issue new membership certificates to all owners that reflect the new percentages.
Sound complicated? Your best bet, whether your business is an S-corporation, a C-corporation, or an LLC, is to consult the professionals—lawyers and tax attorneys—because every business, document, and state is slightly different. They’ll make sure that you understand and fill out the necessary paperwork. They’ll also advise you on whether or not signing a personal guarantee makes sense given your specific personal financial situation.
Jimmy and John’s Landscaping Business
Let’s illustrate with an example.
John and Jimmy are partners with a new seasonal landscaping business. Jimmy, who owns 30% of the company, has a personal credit score of 620. John owns 70% and has a stellar credit score of 700. Both of these credit scores are pretty good, so they shouldn’t have trouble receiving approval for that $50,000 loan they need in order to purchase new equipment.
Because they both hold more than 20%, their lender will need each to sign a personal guarantee. But Jimmy has a wife and three teenage kids, and he knows that if he signs the personal guarantee and their new business fails, he might have to worry about his house and children’s college funds. Understandably, Jimmy doesn’t want to sign and put his family at risk.
(Now, it’s pretty unlikely that their business would fail before any of that loan gets paid off, and Jimmy only owns 30% of the business anyway. The business’s assets would get liquidated first, so chances are, Jimmy wouldn’t have to sell his house or break too many piggy banks. But there’s no harm in being wary!)
In this situation, one option would be to transfer 15% of Jimmy’s ownership percentage to John, so that he no longer has to sign a personal guarantee.
How do they do that?
Remember that the process depends on the setup of the company. Their business is an S-corporation, so first they consult their tax attorney, who can value their company’s stock. Then, with the help of their lawyer, Jimmy transfers some of his shares to John using a stock repurchase agreement. Their lawyer destroys their old stock certificates, issues them new ones, and updates their company stock ledger. Finally, Jimmy and John file their new information with their state’s Secretary of State.
Once all of these steps have been completed, they can apply for a loan. Now that John owns 85% of the company and Jimmy only 15%, Jimmy’s off the hook for signing a personal guarantee.
When Shouldn’t you Change your Ownership Percentage?
One of the most common reasons for small business owners to change their ownership percentages is the case where a majority owner has poor credit. Although restructuring ownership in order to qualify for a loan makes sense here from the business’s point of view, it can be a red flag to lenders, whose underwriters are experienced in sniffing out these types of situations. They won’t necessarily be jumping to offer your business a loan if it’s clear that a partner with bad credit is still managing the company, despite a recent switch from 25% to 15% ownership.
The better option here is to find a lender that’s a good fit for you, rather than trying to fit yourself to a good lender. Go for a lender that’ll offer you a loan at your current ownership structure instead of changing ownership percentages. You might have to deal with higher interest rates in this case, but responsibly paying back a high-interest loan builds credit and will make it possible to secure lower-interest loans in the future—without changing your ownership percentages.
Lender Ownership Percentage Requirements
Now that you have the basics of ownership percentages and personal guarantees down, let’s talk specifics. Every lender has different requirements for personal guarantors in terms of ownership percentage, credit score, and duration of equity ownership in the company.
For an SBA 7(a) term loan, one of the most popular general small business loan programs, all business owners with more than a 20% share in the company will be required to sign a personal guarantee. You have the SBA to thank for setting this trend—many other lenders followed its example and adopted the same policy.
Some lenders do have slightly less strict requirements. Direct Capital, for example, doesn’t require all of the ownership to be accounted for with a personal guarantee. Vice President of Client Services Scott Lynch says, “We typically require 80% ownership to PG, whether that means four owners at 20% each or one owner at 80%.”
Short-term lenders will require an even lower percentage of ownership to be personally guaranteed. Although these percentages vary from lender to lender, as a general rule, only 50% of ownership will need to be accounted for with a personal guarantee for a short-term loan. In these cases, one reluctant partner won’t necessarily hold up your application as long as their equity share is below the necessary percentage.
And some short-term lenders, like QuarterSpot, don’t require personal guarantees at all. These types of loans might not offer the best interest rates and repayment structure, but they’re important options if you’re truly unable to work around the personal guarantee obstacle. This is also true for Merchant Cash Advances (MCAs).
If you’re a small business owner with several partners, and those personal guarantees are holding up your loan application, it might be worthwhile to look into changing around the percentages of ownership among your company’s partners. But if your problem is a low credit score, proceed carefully. Lenders can be savvy to last-minute changes in ownership, especially if they aren’t accompanied by any changes in management or workload.
We hope you’ve got a solid overview of the relationship between personal guarantees and ownership percentages. If you decide to restructure, remember: the best thing that you can do is call in tax and legal experts. They’re the ones who will best understand your business and finances and help you navigate these complex, slippery documents and procedures.
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from Fundera Ledger https://www.fundera.com/blog/2016/03/08/ownership-percentage/