Discussing bank loans backed by personal guarantees is a common conversation I have with founders and financial partners. This is because 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 that are backed by a personal guarantee successfully used to access non-dilutive capital to fund incredible growth in tech companies at competitive rates and favourable terms. I’ve also met startups that found a personal guarantee for securing a loan to not be the right fit, and instead look for alternative ways to secure needed financing.
When doing research for this post about personal guarantees, I was surprised to discover how little is written on this topic. Perhaps no one wants to touch on a topic that has legal implications, or maybe it’s a misunderstood topic? Whatever the reason, I felt this was a good reason 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:
A Frog & Collateral
One day a frog goes into a bank looking to get a loan. He approaches the bank teller and asks her name. “I’m Mrs. Paddywack” she replies. “I would like to apply for a loan” the frog says. “Great you came to the right place! Do you have any collateral?” says Mrs. Paddywack. The frog thinks for a moment and then digs in his pockets but can’t find anything except a small knickknack that he has been carrying around. “How about this knickknack?” he asks. “I’m not sure if that will work but let me go check with my manager,” she says. She goes to her manager and explains the situation and that she is not sure if the item will work as collateral. “Do you think we can lend to this nice Frog?” she asks her manager. The bank manager thinks about it for a second, jumps up from his seat and says: “Yes, of course, we can. It’s a Knickknack Paddywack give the frog a loan!”
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.
It’s common to find that many tech companies don’t have traditional forms of security on their balance sheet, those usually include: real estate, equipment, or the physical knickknacks that typically secure loans.
Regardless, there is another way business can offer security for loans—the personal guarantee.
What is a personal guarantee?
For anyone unfamiliar with what a personal guarantee is, said simply—it is a security document (agreement) that banks and lenders can request outlining that the person who signs is responsible for repaying the borrowed amount in the event the business is not able to make its contractually obligated payments.
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.
Financing Technology Startups with Personal Guarantees
From Brick-and-Mortar to Tech Lending
So why is this form of security being used in tech now? Since it has always been used in Small and Medium Business lending (especially the early-stage companies), once banks started lending to tech startups, it has made its way over to tech lending as well.
Something that is often left out of the conversation on Personal Guarantees is the fact that they are actually an extremely common form of security in Brick-and-Mortar3 businesses. Although, there is likely no owner anywhere that likes the idea of providing a personal guarantee. However, the owners of these businesses are generally less resistant to offering them as security. There are a couple of reasons for this. First of all, when there are physical assets in the business, usually the business owners understand the value of their own assets even better than the bank would.
A calculation might go like this for example: if a company has $2MM in equipment on the balance sheet, the bank might underwrite that collateral value as 2MM x 65%4 = 1.3MM in Collateral Value. So if they are borrowing $2MM from the bank, the bank might suggest that they need a Personal Guarantee to get the deal done. The business owner themselves might know clearly that the equipment is worth more than that – let’s assume the owners believe the equipment to be worth $2.2MM in a liquidation sale scenario (they may have contacts or sold pieces of equipment before that give this confidence). In the end, the founders may not like the idea of the guarantee but also might trust the other forms of security offered. They may also negotiate the personal guarantee, but I’ll go into this negotiation process with some tips a bit further down.
This is a bit different from a distressed loan situation in a technology business where it could be challenging to sell a startup’s accumulated assets to repay a loan.
Personal Guarantees and Startups
So how do personal guarantees work for financing startups?
In addition to not having the physical assets that a brick-and-mortar business would have, there is also the challenge that comes from the underlying assumption that most startups fail.
I would caution that these numbers include all startups, not just the ones that would qualify for bank loans. These stats include companies that never generate revenue or move beyond the idea stage (which has a high death rate). There are metrics and milestones to qualify for a loan (such as minimum revenue amounts) that separate some of the bank-financed companies from the ones that fail in these numbers. I wrote more about timing and metrics for term loans in Financing a Tech Company’s growth with Term Loans – It’s all about Timing
Put the lack of assets and the fact that a significant amount of startups fail together into one scenario, and you can see why lenders are requesting additional security for their loans. It’s actually also why founders could be reluctant to give it.
While personal guarantees are an extremely common lending tool for growing small businesses, in the startup world when companies have the ability to sell equity a great question to ask is whether this form of security is necessary to give. Why not ride investor capital and leave all the risk in the business? This is definitely an option so let’s look into it.
What do Investors think?
Despite its undeniable popularity, some investors still don’t like the use of Venture Debt at all. Layer on the fact that some lending requires Personal Guarantees and you could lose them completely. So why don’t investors like it? There are a few reasons, but it mostly comes down to the fact that debt in startups will amplify both the risks and the returns of an investment. If a startup is already risky, does it need leverage to amplify this risk? I wrote about this in more detail in this post: What is Venture debt.
Venture debt in some situations is a competitor to venture capital and in others, a compliment to it – but it makes their deals a bit more challenging. Investors want companies to shoot for the moon (providing >10x return). An extremely relevant argument to consider is that financing with a personal guarantee-backed loan could cause founders to be a bit more cautious and conservative rather than aim for hyper-growth that Venture Capital aspires for.
Most hyper-growth startups are completely focused on equity financing or raising capital. This model of financing has de-risked founders from personal liability if the business fails. Founders take substantial risks with their careers, time, and opportunity, and equity-financing has created the idea that a company can potentially go from raising Pre-seed, Seed and Series A,B,C – all the way to IPO5 without a founder ever risking their personal financial situation. This can be an exceptional way to build a company.
So why doesn’t every company do it this way? In addition to the obvious downside of ownership dilution with each raise, is the fact that even exceptional startups might not attract investment capital at the time that they need it most. The chart below shows that most financing for startups doesn’t actually come from investors. Here are the results of decade-long research identified from the 5,000+ entrepreneurs interviewed by the Kaufman Foundation which shows where their funding came from.
With Bank and other Loans accounting for 34.9% of funding, it’s clear why personal guarantees come into play so often. Considering that founders’ personal savings makeup 30% also increases the relevance of personal guarantees. This is because a personally guaranteed loan can offer an alternative to directly financing the business by using personal assets (ie: cash injections into the company). Notice that Venture Capital only accounts for 4.4% of all funding here.
Taking a loan with a personal guarantee does not exclude companies from taking investor capital either. I have seen loans with personal guarantees taken by companies backed by Venture Capital and also used to grow an early-stage company’s revenue to then qualify for Venture Capital. Keep in mind that if a company wants to go to a full equity model of financing, they can always pay back a loan and have the security released. Really, there is more than one way to finance growth and using a mix of financing options is becoming more and more popular at various stages. I went into the benefits and downfalls of various options in more detail in the post: Pros and Cons of Tech Financing Options – Debt, Equity and Bootstrapping.
Alternatives when a Personal Guarantee is not an Option
So what if a personal guarantee is off the table? Well, there are still some great alternative financing options available. The major caveat (and one that is really not clear to most borrowers) is that these options are going to either have short-term repayment periods or be more expensive than a bank loan would be – or both.
There are also many great venture debt lenders6 that will fund later-stage companies without guarantees. These companies will usually have crossed a minimum threshold of 250K Monthly Recurring Revenue or 3MM Annual Revenues. Since this post is more focused on early-stage companies, I won’t go into too much detail on these companies here and will save this for another post.
Not requiring a Personal Guarantee can be a strong differentiator for private lenders compared to banks. This makes it a great marketing tool for lenders that don’t require it. This is where Merchant Cash Advances are taking off. Companies like Clearco, Shopify Capital, and Stripe all offer them (I wrote about Merchant Cash Advances in detail here).
So what’s the catch?
- These alternatives can come with a large price difference from those that use personal guarantees. Annual Percentage Rate7 on these products can range from 15%-30% (or even higher) depending on repayment terms. Keep in mind that the fee or discount rate is not the annual interest rate (ie: a 6% fee repaid in 3 months is actually a 24% APR).
- Something that is actually much more important to consider than just the annual rate, is that the repayment period is usually on a very short term (usually within 1 year). Although the APR for alternatives is still technically cheaper than equity (assuming the company is a high-growth startup), short repayment periods can be very hard on cash flow if your company is not growing rapidly. Bank loans will have longer terms like 48-60 months and could include interest only periods.
Another exciting new company, Pipe, has an offering where you trade your Recurring revenue for an upfront payment at a discounted rate. This has similarities to how a factoring company works, where companies would sell their Account Receivables. In Pipe’s model, you can sell your Monthly or Annual Recurring Revenue at a discounted rate to have the funds available upfront and pay it back over the year. I’m planning on doing a deep dive into Pipe in a future post, but here are some great resources in the meantime8.
These alternative models of financing can be extremely helpful for immediate financing needs and fund growth that increases both a company’s valuation and gets them to the next stage of their business. The simplicity of using the tech-enabled platforms and the lack of personal guarantee make them very enticing options for the right companies.
If the option of providing a personal guarantee seems worth pursuing, you may have or be able to build some negotiating leverage. Here is how to do it.
How to Negotiate a Personal Guarantee
Understand the types of Personal Guarantees
All Personal Guarantees are not made equal and understanding the different types of Personal Guarantees can help this discussion. I would also strongly recommend hiring a lawyer to review all your security documents since even a single word like “unlimited” on a Personal Guarantee can change the meaning of what you are committing to9. Here are a few types to know about.
- Limited: This means that the guarantee is limited to a certain amount that is predetermined and outlined in the security agreement.
- Limited to a percentage: This means that your exposure would be limited to a percentage of the loan. This percentage could be to the amount initially borrowed or to the balance outstanding. These are common when there are multiple owners that are guaranteeing their ownership portion of the loan.
- Limited to a dollar amount: This means that the guarantee is limited to a specific dollar amount that is determined in the agreement.
- Unlimited: Unlimited guarantees are usually taken in lending when there is an expectation or potential that the borrowing amount could increase with the lender. The security is already in place for this increase.
Questions to Ask your Lender
- Find out if the Personal Guarantee is a deal-breaker. Are there other forms of security that could be offered? If it is a requirement and you are not willing to sign one, it doesn’t make sense to continue the conversation much futher -it could save time not to continue if its a non-starter. Although personally, I would suggest understanding the full offer before shutting down a conversation based on this one piece of security. If you receive a term sheet from your lender I wrote a guide here for Reviewing a Debt Term Sheet.
- Understand which type of Personal Guarantee you are being asked to provide and whether you are comfortable with that type – Limited/Unlimited and Limited to a percentage of the Loan or a set dollar amount. Does the guarantee decrease with repayment of the loan or is it a fixed amount?
- Discuss performance metrics that could be met to achieve a reduction or release of a guarantee. It’s great to know what a lender sees as strong performance from the company at the start of the relationship. Keep in mind that if a release of a guarantee is the goal, it could also signal to a lender that the plan is to take the loan and repay it rather than increase borrowing as your needs increase.
Know when to Negotiate
Another key is knowing when to negotiate. There are three things that will give you the most negotiating power with a personal guarantee.
- A strong balance sheet – Lenders like to give loans when the balance sheet is strong and there is equity in the company. This is why with venture debt its common to see a loan given right after a capital raise or at the same time as a raise – the incoming cash strengthens the company’s balance sheet.
- History with your lender – A longer-term existing relationship leads to more negotiation power.
- After a financial year-end with a strong financial performance – After a strong growth year is a great time to discuss your situation with your lender. You may want to ask about the security or consider requesting an increase to your loan amount to continue growing with more capital.
How about when not to negotiate a personal guarantee? After a year with low or no growth is likely a time to avoid this discussion. This can be a negative signal to your lender that you are not confident in the companies future and could cause more issues.
- Personal Guarantees are a form of security that are commonly used in small and medium business lending that can give startups access to non-dilutive capital.
- Not using a Personal Guarantee can mean using an alternative with a higher annual interest rate and lower amortization.
- Personal guarantees can cause founders to act more conservatively which might not be what investors want to see.
- Understanding the banks motivations for taking personal guarantees can help in negotiations.
- It’s worth considering if this type of loan is a fit for your business.
(1) The Business Development Bank of Canada has over $3B in loans and investments to over 3,000+ companies
(2) Key person insurance is a life insurance policy that a company purchases on the life of an owner, a top executive, or another individual considered critical to the business.
(3) Brick-and-Mortar businesses is a term that refers to companies that have physical locations and assets. Examples are manufacturing businesses or restaurants.
(4) In this case, 65% would represent the bank’s margin amount or Loss Given Default amount that they expect to be able to recover in liquidation.
(5) An IPO is an initial public offering. In an IPO, a privately owned company lists its shares on a stock exchange, making them available for purchase by the general public.
(6) This includes CIBC Innovation Banking, Silicon Valley Bank, TIMIA Capital, Flow Capital, and many more. For earlier stage SaaS companies Lighter Capital is also an option.
(7) Annual Percentage Rate is the annual amount paid for a loan. The calculation is as follows: Add total interest paid and fees over the duration of the loan. Divide by the amount of the loan. Divide by the total number of days in the loan term. Multiply by 365 to find the annual rate. Multiply by 100 to convert the annual rate into a percentage.
(8) Articles on Pipe: by founder Harry Hurst here, and Packy McCormick here. I will write my own soon.
(9) Nothing in this post is legal advice. I am not a lawyer. You should have one though.