Personal guarantees and collateral when you borrow to buy

When you borrow to buy a business, the loan is usually made to the company you set up for the purchase. But lenders rarely rely on a small company alone. They want a person standing behind the loan, and property they can claim if it isn't repaid. Those are the personal guarantee and the collateral.

Neither is a reason to give up on buying a business. Both are reasons to understand exactly what you're signing. This post covers the basics in plain words. How they apply to you is a conversation for your lender and an attorney.

What a personal guarantee is

A personal guarantee is your promise that if the company can't repay the loan, you will. If the business fails and selling its assets doesn't cover what's owed, the lender can come after you personally for the rest.

That matters because of how you'll likely set things up. You'll probably form an LLC or a corporation to own the business, and that structure generally keeps the company's debts separate from your personal finances. A personal guarantee is the exception you agree to: for that debt, the separation doesn't protect you.

Guarantees come in two broad kinds:

• Unlimited: you're responsible for the whole balance, and usually the interest and the lender's costs of collecting.
• Limited: your responsibility is capped, at a dollar amount or a share of the loan.

A guarantee usually lasts until the loan is repaid, unless the lender agrees in writing to release you.

Why lenders ask for one

Much of what you pay for a small company is its earning power: the customers, the reputation, the team. If the company fails, those are worth little to a lender, and the trucks and equipment left behind rarely cover the loan.

A guarantee also shows the lender that the person running the company has every reason to make it work. It's a normal part of borrowing to buy a small business, not a sign that the lender doubts you.

The SBA's rules on guarantees

Many small business purchases are financed with SBA 7(a) loans: bank loans partly guaranteed by the U.S. Small Business Administration. The SBA's rulebook for lenders, its Standard Operating Procedure 50 10, requires anyone who owns 20% or more of the borrowing company to give an unlimited personal guarantee. The lender can also ask other people to guarantee the loan when it decides that's needed, whatever share they own.

So if you buy with a partner and you each own half, you each guarantee the whole loan.

For loans without an SBA guarantee, lenders usually ask for personal guarantees too, and the terms vary more from lender to lender.

What collateral is

Collateral is property the lender can take and sell if the loan isn't repaid. The lender's legal claim on it is called a lien.

On a loan to buy a business, the lender typically takes a lien on the assets you're buying: equipment, vehicles, inventory and money customers owe. When it measures how far those cover the loan, a lender counts used equipment at well below what you paid, closer to what it would bring in a quick sale. Since much of the price pays for earnings rather than things, business assets alone often fall short.

When your home becomes collateral

This is the part that gives buyers pause, so it's worth being precise.

Under the SBA's rules for 7(a) loans, the lender has to look further when the business assets don't fully cover the loan. It must take available equity in real estate owned by anyone with 20% or more of the company and by the guarantors, including a home. (For property owned jointly with a spouse, the rule is that the lender must consider taking it.) Equity is what the property is worth minus what you owe on it. A few points soften this:

• The SBA doesn't require a lien on real estate when the equity is less than 25% of the property's market value.
• The lien may be limited to the amount of the shortfall.
• An SBA loan isn't supposed to be turned down only because collateral is short. A lien on your home is how the gap gets covered when the equity is there.

Here's a hypothetical. Say you buy a landscaping company for $900,000. You put in about $90,000 as a 10% down payment, plus about $36,000 for closing costs, and borrow about $810,000. Suppose the lender counts the trucks, mowers and trailers as $200,000 of collateral. That leaves a shortfall of about $610,000.

• If your home is worth $500,000 and you owe $300,000 on it, you have $200,000 of equity: 40% of its value. Expect the lender to take a lien on it, typically a second mortgage behind the one you already have.
• If you owe $420,000 instead, your $80,000 of equity is 16% of the value, under the SBA's threshold. The SBA wouldn't require a lien, though a lender may still ask for one.

Two more things to know. The SBA's rules still count real estate an owner transferred to a spouse or minor children in the six months before applying, so moving the house into a spouse's name isn't a way around this. And a spouse who owns none of the business may still be asked to sign a limited guarantee, so the lender can take a lien on a home you own together.

In Florida, the state constitution (Article X, Section 4) protects a homestead from forced sale for most debts, but it lets an owner mortgage the home, joined by the spouse if married. A lien you sign to secure a loan is a mortgage of that kind. How this works for your home is a question for a Florida attorney, before you sign anything.

Ways to reduce your exposure

You usually can't avoid a guarantee on an SBA loan, but you can shape how much is at stake:

• Borrow less. More cash down, or a seller who agrees to be paid part of the price over time, means a smaller bank loan and a smaller shortfall. See price versus terms for how structure changes a deal. A seller who finances part of the price may want a guarantee as well.
• Ask about the lien. Ask whether a lien on your home can be limited to the shortfall, and whether the lender would ever release it before the loan is paid off. Get any answer in writing.
• Count every guarantee. The bank loan, a seller note, the commercial lease and equipment financing may each ask for one. Add them up before you decide how much risk you're carrying.
• Insure yourself. If an SBA loan isn't fully covered by collateral and the business depends on you as its one active owner, SBA rules require life insurance on you for the amount of the shortfall. Beyond that, life and disability insurance can keep a guarantee from landing on your family if something happens to you. Ask your lender what it will require, and an insurance agent what fits.
• Talk at home first. A guarantee and a lien on your house affect everyone who lives there. Have that conversation before you make an offer, not the week of closing. It belongs with the other questions to answer before you search.

Questions to ask this week

Ask a lender:

• Whether they'll need a personal guarantee, from whom, and whether it will be unlimited.
• How they'd value the business assets as collateral, for the kind of company you're looking at.
• When they'd need a lien on your home, and whether it could be limited to the shortfall.
• Whether they would ever release that lien before the loan is paid off.

Ask an attorney:

• Exactly what you'd be liable for under the guarantee, including interest and collection costs.
• Whether, if you buy with a partner, the lender could come after you for the whole amount.
• How a lien would affect your home, given how you and your spouse own it.