We’ve all heard that one purpose for incorporating a business is to protect the owner’s personal assets from any debts incurred by the business. Although that reason is completely valid, in some instances, forming a corporation may mean that the business is unable to obtain credit. For individuals, banks and lending institutions rely heavily on credit scores and other sources of information to evaluate and predict a borrower’s ability to repay loans. However, when a business, particularly a new one, attempts to obtain credit or enter into a lease, there may be no information, or insufficient information, available to potential lenders or lessors upon which they may evaluate the ability of the business to repay loans and make lease payments.

Often, small and new business are asked in the lending process or negotiations for a lease to sign a “personal guarantee,” in addition to providing information the lender and/or lessor will use to evaluate the business’s ability to pay. But what exactly is a personal guarantee and why are you, as the owner of a small business (or corporation), asked to sign one? A “personal guarantee” is simply a written, unsecured promise by the business owner agreeing to be personally liable to the lenders or lessors in the event of the business’s default. The personal guarantee, once signed and delivered, allows the lender or lessor to look to the owner of the business individually if the business fails to repay the loan or fails to pay the monthly lease payment when it is due.

The following example describes what happens when the owner of ABC Corporation borrows $100,000.00 from Bank of America:

ABC Corporation borrows $100,000.00 at 4% interest from Bank of America on November 1, 2015 and agrees to make monthly payments of $2,000.00 per month until the entire sum is repaid, together with interest. In March 2016 owner of ABC Corporation is involved in an automobile accident and ABC Corporation’s profits plummet. As a result, ABC Corporation is unable to make the $2,000.00 payments, becomes insolvent and defaults on its obligation to Bank of America. The owner of ABC Corporation, however, has substantial personal assets worth $5,000,000.00.

In the above example, if Bank of America failed to obtain a personal guarantee it would simply be entitled to whatever proceeds are available to pay the general unsecured creditors of ABC Corporation, and owner’s personal assets of $5,000,000.00 could not be used to satisfy ABC Corporation’s obligation. However, if the owner signed a personal guarantee, Bank of America would be entitled to seek repayment of its loan to ABC Corporation from the owner. In the event the owner failed or refused to repay the loan, Bank of America would be entitled to institute a suit against the owner and, if successful, would be entitled to seek satisfaction of any judgment directly from the owner’s personal assets.

Although it is not uncommon for lenders and lessor to ask the owner of a small business to sign a personal guarantee (and even ask the owner’s spouse to sign), you should ensure that you understand exactly what you are signing. Moreover, if you are not a member of the executive management team of the business, or the sole owner of the business, you probably do not have a full understanding of the business that would allow you to make an informed decision whether to sign the personal guarantee. Generally, if you are not a member of the executive management team or the sole business owner, you should not sign a personal guarantee.

Each business and business entity is unique. To understand the different options and which direction will be best for your situation, you need to consult with an experienced corporate attorney. Michael Leonard, Esq. of San Diego Corporate Law, named “Best of the Bar” by the San Diego Business Journal in 2016, has the expertise to guide you through everything from forming your business, to creating buy-sell agreements, to executing contracts, and anything in between. To schedule a consultation to discuss any business-related matter, please contact Mr. Leonard by visiting San Diego Corporate Law or by telephone at (858) 483-9200.