One of the first steps in any business venture is for the founder to form a business entity separating their personal assets and liabilities from the business assets and liabilities of the new company. Without this separation, all of a founder's personal assets would be at risk to creditors of the business, but with the separation and absent other factors, creditors of the business can only look to a business's assets to satisfy its debts.
But sometimes in the ordinary course of business, a company may find that someone with whom it would like to do business requires a personal guarantee from the company's founder. Perhaps a bank wants the founder's personal guarantee before issuing a loan to the company. Or maybe it's a landlord who wants a personal guarantee from the founder before leasing space to the company.
While founders may be eager and willing to do whatever it takes to get that loan or lease that space to continue building the business, owners need to be keenly aware of the personal risks and liabilities that they take on when they give a personal guarantee.
A personal guarantee is an individual (in this case, the founder) agreeing to be personally liable for the company's obligations under the agreement to which the personal guarantee relates. In effect, the personal guarantee unwinds the separation of business liabilities and personal liabilities. If the company does not satisfy its obligations, the counterparty can look to the guarantor to satisfy those obligations.
Consider a company that needs to borrow $1 million from the bank, and the bank asks for a personal guarantee from the founder. If the company fails to repay the $1 million, the bank can look to collect the unpaid balance of the loan from the founder's personal assets, including their home, car, bank accounts, and other assets.
Given the significant personal risk that a personal guarantee can create for a company founder, keep the following in mind with personal guarantees:
- Look for alternatives. Determine if the transaction can still happen without the personal guarantee. Perhaps the company would need to take on slightly less favorable terms, but doing so may be worth it to keep the founder from exposing himself or herself to personal liability.
- Spread the risk. If there are multiple founders, and all of them are being asked to give personal guarantees, negotiate for each founder to guarantee a portion of the company's liabilities equal to that founder's ownership interest in the company. For example, if a founder only owns 10% of the business, that founder should try to negotiate to only be personally responsible for 10% of the company's obligations.
- Set caps. Include limits on both how long the personal guarantee will apply and also the total amount that the founder is personally liable for. So instead of guaranteeing the full amount of a loan forever, try to only guarantee 50% (or some other portion) of the loan for only so long as there is an outstanding balance.
During the early stages of a company, it's easy for a founder to see all the potential upsides of that company and adopt a "do whatever it takes" attitude to grow the business, which may mean giving out one or more personal guarantees for the sake of securing a loan or closing a transaction.
However, before doing so, a founder should clearly understand that giving a personal guarantee means undoing the separation between personal and business liabilities, and all the associated risks that come with taking such action if, in the end, the company doesn't succeed or takes longer than expected to reach profitability.