One of the features touted when discussing incorporation or organization of a limited liability company (LLC) is limited liability. In other words, by forming a corporation or LLC (or other limited liability entity) you shield your personal assets from most business liabilities. There are instances where your entity will not shield you from business liabilities but we'll cover that another time. Today we're discussing personal guarantees which normally arise during the formation process or shortly thereafter.
As a newly formed entity there is no credit history for your entity. Remember back to when you were 18. No matter where you were, credit card companies found you. And they offered you credit. But not much. My first card had a $500 limit. Why was my limit so low? I didn't have bad credit, but I had no credit. My credit history was too short. Maybe if my parents co-signed I would have gotten a higher limit. The same risks are associated with a new company. With no credit history, the lender has no way of knowing the risk profile of the new business. There may be no recourse if the entity should go belly up. It also opens up the possibility of fraud in some cases, if no individual will offer up a personal guaranty.
A personal guaranty is essentially what it sounds like, a guaranty from the person soliciting the loan/credit/contract on behalf of the entity. This usually includes residential leases, loans and some other business related contracts. Whoever agrees to the guaranty is putting up all of their personal assets in order to complete the deal. This may sound like it defeats the purpose of the entity, but it should not be viewed as that way. When you start a business in earnest you're not assuming it will fail anytime soon. If everything goes as planned you will have a successful business and when you have established enough business credit, you may seek to lift your personal guaranty and rely solely on the credit of the entity.
This is quite common among small businesses when first beginning operations so don't be alarmed, but be aware of what a personal guaranty entails.
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Joseph -
A personal guaranty will often be required even after the business begins establishing credit if the business is closely held.
If there is only one principal owner (or a few related owners) then they control the business assets and can easily strip the cash and value out of the business. A closely-held business can easily be stripped to a shell. So most lenders will require the principals to personally guarantee the debt even after the business grows and prospers.
Yes Doug, thank you Doug for pointing that out, and thanks for reading my blog.
I have seen businesses successfully withdraw their personal guaranty from real estate leases after several years of tenancy. But in light of the recent credit crisis your point is well made, as lenders are even hesitant to give credit to businesses with a low risk profile.