Small business owners and managers face a potential ticking time bomb in the wake of the pandemic. New research suggests that hundreds of thousands of people have endangered their personal property, including their homes. Last year, more than a third of small businesses took out loans with personal guarantees, according to Purbeck Insurance.
Small businesses typically manage their finances, including borrowing, separately from the personal affairs of their owners and directors. This protects the owners if the business fails because the lenders cannot sue them personally for the unpaid debts.
However, when lenders fear the risk of lending to businesses, they may require personal collateral from directors or owners. The guarantor is then legally responsible for settling the debt if the business cannot meet the repayments. Lenders can seek guarantors for unpaid loans, requiring that they sell personal property, including a family home, in order to pay what is owed.
Under state-backed Covid-19 initiatives, such as the Coronavirus Business Interruption Loan Program (CBILS), lenders were generally prohibited from requiring personal guarantees. But this did not apply to the bulk of these loans, nor to loans taken out outside these regimes. In Purbeck’s survey, 24% of small businesses said they took out unsecured government loans with personal guarantees, while an additional 10% took out CBILS loans large enough that lenders were eligible for credit. ‘require such a guarantee.
Personal guarantees can make sense in certain circumstances. If your business is running out of assets – a problem for many companies in the service industry, for example – it may struggle to fund itself even if it trades well. A personal guarantee, if you are sure it will never be called upon, can then be a way to raise funds for growth purposes at an affordable interest rate.
How to mitigate the risks
However, it is essential to enter into personal guarantee agreements with your eyes open, ideally taking legal and financial advice. There are pitfalls that can catch the unwary, and steps you can take to mitigate the risk. Check the terms of the guarantees carefully. In some cases, lenders may demand immediate repayment, often without the ability to negotiate repayment terms. You can also be online for bank charges, including if you decide to prepay the loan. And when several directors provide personal guarantees “jointly and severally”, the bank may not have to expel them all; he may demand the entire amount from a single director.
There may be room to ask for better terms to protect yourself. Lenders may be willing to exempt certain assets from collateral – the family home, for example – if there are other assets of sufficient value to provide security. Alternatively, non-recourse loans, where lenders have no claims beyond certain assets, even if those are not enough to pay off the debt, can be reassuring.
If you are not the sole owner of the business, you may want to look for additional protections when setting up personal guarantees. For example, you might want to agree on a list of issues the company can’t make decisions about without your consent. You may want arrangements requiring the company to pay off the loan once it has sufficient funds, before making any other commitments. You also need to understand your position if you were to leave the company – or be fired.
Finally, personal insurance, available from a small but growing number of specialist insurers, also deserves to be considered. This covers part of the cost of repaying the loan if the business cannot handle it – up to 80% with some policies. This reduces the liability of the guarantor. Insurance can be purchased for existing personal guarantees as well as new ones, which can offer some protection for those who borrowed in the last year.