Because it has become difficult to get business loans through the normal channels, you might be tempted to investigate and possibly take advantage of alternative financing schemes. This course of action might not always be prudent.
“It doesn’t hurt to look at alternative lenders,” says Mike Petersen, a partner at Shulman Hodges & Bastian LLP. “But first consider your side of the lending relationship — particularly if you have deposits. Be aware that credit is less available and lending terms are changing because of the state of the economy. Valuations of assets are changing, too, even though the assets themselves might not be changing.”
Smart Business talked to Petersen about assessing the risks of taking out loans that involve personal guaranties and hard money.
What are personal guaranties, and how can they put you at risk?
A personal guaranty means that you are personally liable for the payment of your company’s obligations. If the company defaults on its obligation to pay a debt, a personal guaranty allows the creditor to bring legal action against you and your personal assets. Although retirement plans offer some protection from creditors, most other personal assets are generally subject to this action, including homes subject to a homeowner exemption, which in most states is quite modest.
Before entering into a personal guaranty, you have to realize that it is not for your benefit, but the benefit of the lender. If all goes well, the guaranty doesn’t matter, but if your company’s financial situation goes south, the guaranty can hurt you significantly.
Most businesses start with an entrepreneur assuming a personal guaranty. When the business becomes successful and viable and has a credit line of its own, that’s the time for the entrepreneur to get his or her name off the guaranty.
How can a business owner limit the reach of a personal guaranty?
You certainly want to be careful about signing a guaranty without fixing finite obligations.
If you have the bargaining power, you can limit it to a fixed dollar amount, which can be smaller than the loan. As credit gets tighter, however, this option becomes less feasible.
The other factor you could negotiate is a homestead exception to protect your house (and proceeds from the house if you sell it and move elsewhere). Similarly, you can carve out other assets from the reach of the guaranty, such as a bank account set up to provide college funds for children.
Finally, avoid self-renewing guaranties that apply to loans beyond what you’re borrowing for today. That is something a wise borrower should be able to negotiate, even in these times. Without a sunset provision, you can be held to a guaranty executed years ago.
What about credit lines and company credit cards?
Company credit cards often require a personal guaranty from the person to whom the card is issued. When the card is issued to a business and the business is in financial distress or financial extremes and there is a high balance, you can get stuck with paying the balance.
If you have a guarantied revolving credit line, your obligation does not go away just because you paid it off. The line will have zero against it, but if you draw down on it after it is reduced to zero, the guaranty still applies to the new debt you’ve incurred on that line.
You cannot afford to forget about any guaranties you sign on or revolving lines. The guaranty is on the line of credit established with the bank 10, 15 or 20 years ago, and it is effective as long as the credit line exists.
What is ‘hard money lending,’ and what are the dangers of it?
Hard money lending refers to lenders that are charging much higher rates of interest than traditional lenders. They tend to quote rates in percent per month rather than percent per annum — typically, 3 percent to 5 percent per month. These loans are entered into on a short-term basis to meet a particular business need or take advantage of a particular high-profit opportunity.
It is rarely the sort of loan a company should take out, because the risk is so great if things go badly: You can lose your whole business and its assets.
What advice are you offering clients who might be contemplating taking out a nontraditional loan?
The root cause of our problems today are people who borrowed money that they could not pay back. So don’t borrow more than you are very sure you can pay back.
Look at the terms of the loan, including its length. Examine the costs of borrowing, like interest and various fees. Before signing the papers, consider scenarios where your business might not do as well as planned.
The higher the rate of interest and ‘cost’ of the loan, the greater the risk of something going wrong and the situation fast becoming a disaster.
MIKE PETERSEN is a partner in the law firm of Shulman Hodges & Bastian LLP. Reach him at email@example.com or (949) 340-3400.