Lending money to a small business can be risky. Twenty percent of small businesses fail within their first year, and 50% fail within five years. To avoid being left with nothing if a business goes under, it’s a wise option for lenders to ask the business owners to personally agree to pay back the loan if the business fails. This arrangement is called a personal guarantee.
Personal guarantees are common for small businesses, especially new start-ups. The Small Business Administration does not guarantee loans unless the owner of the business also guarantees the loan. It’s especially important to negotiate a personal guarantee if the loan doesn’t allow for the repossession of assets if the business defaults.
What Is a Personal Guarantee?
The law allows businesses to be incorporated as legal entities separate from their owners. As a separate legal entity, a business has its own assets and liabilities, meaning the owner of the business is not normally personally responsible for its debts. A personal guarantee is a business owner’s agreement to share a liability with the business, guaranteeing that the owner will personally pay the debt if the business does not.
Personal guarantees are one of the key tools a creditor has when lending to small businesses. These businesses, especially new ones, have uncertain prospects and often fail before they are able to turn a profit. Without personal guarantees, creditors could be left with no means to collect on the debt they issued if the business fails.
Enforcing a Personal Guarantee
If a business defaults on its debt, a personal guarantee gives the creditor additional options. Without a personal guarantee, the creditor would only be allowed to pursue the assets of the business itself. As a practical matter, small businesses that can’t pay their debts rarely have significant assets.
With a personal guarantee, the creditor is entitled to payment from the business owner personally. A personal guarantee can be enforced the same way as any debt. If the business owner does not pay, the creditor can bring a lawsuit to receive a judgment and levy the owner’s personal assets to cover the debt.
The exact terms of a personal guarantee specify a creditor’s options under the guarantee. Some guarantees only allow the creditor to collect from the owner personally after a certain number of missed payments. Others restrict the amount the owner is liable for or limit what assets the creditor can pursue. A lawyer can examine a personal guarantee agreement to determine what collection methods are available and when they can be used.
Personal Guarantees and Bankruptcy
As is the case with most debts, bankruptcy can dramatically alter a creditor’s right to payment under a personal guarantee. Exactly how depends on who files for bankruptcy (the business, the business owner, or both) and what chapter of bankruptcy they file under.
If only the business files for bankruptcy, it is still possible to enforce the personal guarantee against the owner. The automatic stay in a chapter 7 or chapter 11 bankruptcy applies only to the bankrupt debtor, not guarantors of debt. Ordinarily, nothing stops a creditor from pursuing collections against a guarantor if the guarantor has not filed for bankruptcy.
Collecting the debt from a business owner works like any other debt collection process unless the guarantee agreement limits the creditor’s rights. If the owner fails to pay voluntarily, the creditor may levy the owner’s assets or garnish the owner’s wages (assuming the owner has a job outside the business) to collect on the debt. If the guarantee involved a lien on property, the creditor may also repossess that property.
In some business bankruptcies, the business may ask the court to prevent a creditor from enforcing a personal guarantee, but courts grant these requests only under exceptional circumstances. Generally, a court will only prohibit a creditor from pursuing a guarantor outside of bankruptcy if the business has other creditors and the guarantor’s assets are key to the business’s reorganization plan.
For example, a bankruptcy court prohibited a bank from repossessing a personal guarantor’s assets because the guarantor had pledged to sell them to fund the operations of the business, which had other creditors. Without the sale, the business would have collapsed, leaving its hundred employees and several other creditors with nothing.
It’s important to note that this situation only arises in a chapter 11 bankruptcy, which seeks to reorganize a business and keep it running. In a chapter 7 liquidation, the business will not continue to operate, so the owner’s personal assets aren’t necessary to the bankruptcy procedure. Accordingly, a creditor with a personal guarantee will almost always be able to pursue the guarantor’s assets outside the bankruptcy.
However, when a small business with personally guaranteed loans fails, it’s common for the business owner to declare bankruptcy as well. If this happens, it’s crucial to contact a lawyer as soon as possible. Once a person files for bankruptcy, creditors can no longer attempt to collect debts from that person except through the bankruptcy proceeding itself. Bankruptcy is highly technical and difficult to navigate without an experienced lawyer.
What Should I Do if I Need to Collect a Personally Guaranteed Debt?
If you’re owed money under a personal guarantee and are having difficulty collecting, contact Rosenblum Law for a free consultation. Our attorneys have represented both creditors and debtors, so we know the process from both sides. Call 888-815-3649 or email us today.