Discussing bank loans backed by personal guarantees is a conversation I’ve had many times with founders and financial partners since personal guarantees are a very common form of security used in non-dilutive debt financing for early-stage companies by banks in Canada1. I’ve seen loans backed by personal guarantees used very successfully to access non-dilutive capital to fund incredible growth in tech companies at both competitive rates and favourable terms. I’ve also met startups where this type of security is not a fit at all and talked with founders that refuse to use them and decide to look for alternatives instead.
When I was researching this post I found it shocking how little is actually written on this topic. It may be that no one wants to touch on a topic that has legal implications, or maybe that it’s not very well understood. Whichever reason it is, both seem like great reasons to write this post and open a discussion on one of the most controversial topics in technology finance, loans backed by personal guarantees.
Since this can be a bit of a heavy topic, let’s start off with one of my favourite “dad” jokes about banking:
Now imagine that the frog has a high-growth tech startup but no knickknacks. The author of this joke didn’t really clarify whether or not the knickknack was a personal asset or a corporate asset but either way, it’s a reminder that most banks are looking for tangible collateral for loans. Most tech companies don’t normally have the traditional forms of security on their balance sheet: real estate, equipment, or the physical knickknacks that typically secure loans. There is another way that they can offer security and that is with a Personal Guarantee.
What is a Personal Guarantee?
A bit about Personal Gurantees:
Loans that are backed by only a personal guarantee are actually considered to be non-collateralized loans. While a personal guarantee is technically a type of collateral, this description is used because a specific asset has not been pledged to support the loan but rather a general agreement between the individual and the lender. These loans are also heavily dependent on the borrower having a good credit score/history.
A personal guarantee would normally not be registered anywhere unless there is a default or collection situation. I would suggest you clarify if this is the case with your lender or lawyer because it is important to know. I have seen comments and posts online with statements like “you can’t get a mortgage if you sign a personal guarantee”. I assume they are talking about going through a default situation and not coming to an agreement with your lender for repayment first – knowing this before you sign is important. Alternatively, a collateralized loan would have a specific asset pledged to secure the loan.
Why are banks asking for a Personal Guarantee?
There are many reasons why a bank may ask for a personal guarantee to support a loan. Here are a few of them.
- They help to mitigate Key-Person Risk. This refers to the risk that is associated with a business being dependent on a single executive (or key group of executives). In a startup, or really in any owner-operated business, the owner-operator in an absolutely essential piece of the business’s success and can even be part of the companies competitive advantage. This is why you might see Key-Person insurance2 required as a condition to a loan as well. A personal guarantee is an easy way for a risk department to mitigate the risk of a key person leaving the business. The guarantee in this scenarios is not seen as a pure asset play but also a form of key person insurance.
- The phone calls get answered when things go wrong. This may come as a surprise to some outside of banking, but there is significant evidence that when things go south on loans supported by personal guarantees, the owners are more willing to work though restructuring and working out a plan for repayment.
- In early-stage businesses, the founder’s personal assets are usually used to start and back the business: Lenders add personal guarantee to serve as a reminder and incentive to the owners to continue to financially back the business. This is more common in small businesses but is still relevant for an early-stage tech startup.
- Betting on yourself (again). If the terms of the proposed loan are fair, and repayment shouldn’t be an issue, then a personal guarantee can be a lender asking the owners to make that bet one more time. This concept can be really contentious for business owners because they have already bet on themselves so many times. Still, banks are asking the question if owners were willing to bet on themselves before then why not this time? Sometimes denying a personal guarantee can suggest or signal that the company is not sure if they can repay at the time of signing the loan. This brings the question of why the company is taking a loan without complete confidence that they can repay it.