Its not uncommon that business owners and managers in search of capital, especially those from businesses with sales under $1,000,000, seek a source of debt financing for their business that doesn’t require them to take any personal risk beyond their investment in the business.
While every business owner would prefer to minimize risk as much as possible, its unrealistic for new or developing businesses to expect lenders and sources of debt financing to take a disproportionate amount of the risk associated with a particular funding request.
In an attempt to avoid risk, owners can spend a lot of time looking for something that may not exist…that being debt financing without any form of a personal guarantee. And while personal guarantees are not always required, they will most likely will be for cheaper sources of debt financing.
And from a lender’s point of view, its not that they are necessarily gaining a great deal of additional security from a personal guarantee, but what they are gaining (at least in their mind) is 150% commitment from the business owner to do whatever it takes to make the business work, versus throwing in the towel when things get tough and letting the lender take a bath.
As businesses grow in size and increase their financial stability through the accumulation of retained earnings, there will be less of a need for personal guarantees to balance off the risk scale.
Personal guarantees or covenants are also closely linked to the type of lender you’re dealing with as well. When there is security pledged, lenders that are either good at liquidating assets or controlling them will be less concerned with personal guarantees compared with a lender taking an unsecured position or accepting security that they aren’t very adept or experienced at liquidating.
The key here is that the risk needs to be somewhat proportionate. If a business owner is asking a lender to take 80%+ of the risk, then it stands to reason that a personal guarantee is going to be required. In situations where there is more risk sharing between the business and the debt financing source then its more likely that a personal guarantee will not be required or at least a partial guarantee may be considered.
As I mentioned earlier, guarantees tend to be linked to the cheaper sources of money which relates to low risk positions for the lender. Higher lender risk will almost always mean a higher cost of financing to offset the risk if the lender is going to be interested in extending funding at all.
While the goal should always be to reduce risk wherever possible, you also have to realistic in terms of taking on a reasonable share of the lending and borrowing risk being entered into.