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As you probably know, personal guarantee for a business loan is a mandatory criterion for most small and big business loans. Most business loans require a personal guarantor to sign off on the loan being lent to a business. This is usually on top of the collateral being submitted for business loans.
What is a personal guarantee for a business loan?
When a business applies for a loan in the bank one of the business owners signs a contract with the bank stating that in the event of default, he/she will be responsible for paying off the debt. This contract serves as the personal guarantee for the business loan.
How does a personal guarantee work?
The process of signing a personal guarantee is incorporated in the process of the loan application. After a business decides to apply for a business loan, it should choose a personal guarantor from the promoters or the directors. These people must have a significant stake in the company and should be ready to shoulder the responsibility of being a guarantor.
If the company later defaults on the loan the guarantor will be liable to pay the rest of the loan even after the bank seizes the collateral submitted. If guarantor fails to pay the loan, the lender has the right to sue the guarantor for the loan amount.
Not all business loans require a personal guarantee. Public limited companies are usually not asked for a personal guarantee while most small businesses are asked to mention a personal guarantor. When the lender is convinced that the collateral provided can cover the risk of the loan, then the lender might agree to extend a business loan without personal guarantee.
Types of personal guarantee
There are two types of personal guarantee:
- Limited guarantee
Personal guarantee where the guarantor signs for a portion of the loan is called limited guarantee. In case the business defaults on the loan, the guarantor only has to pay for the portion of the loan as stated in the contract.
This is usually the case when two or more directors or promoters have signed as personal guarantors of the debt. Here, the agreement would be to split the debt among them, when the company defaults. Each will have to pay for his/her liability.
- Unlimited guarantee
An unlimited guarantee is when the guarantor accepts full liability for the loan. This means that the entire outstanding loan amount on the lender’s books of accounts when the company defaults will have to be paid by the guarantor.
Examples for personal guarantee for business loans
Let us explore some real-life examples of personal guarantee for business loans from a few cases that happened in India.
The Kingfisher Airline scandal is a botched case of personal guarantee. Vijay Mallya had taken many loans from major banks including SBI, Bank of India, IDBI and many others for floating his passenger airline company, Kingfisher Airlines.
According to several newspaper reports, the banks trusted Mallya as he had large political influence and was a well-known figure in the Indian industry. However, personal guarantor personal responsibility for the loans taken. Kingfisher Airlines was seized with all its assets, but the banks are yet to recover close to ₹9000 Crore from Mallya.
Another relevant personal guarantee for business loan example is of Reliance Communications and Reliance Infratel getting business loans sanctioned with Anil Ambani as the personal guarantor. There are plenty of other examples where business owners stand personal guarantee for loans taken among both big and small businesses.
Requirements to become a personal guarantor
A guarantor will have to mention a few details and submit a few documents while applying for the business loan as a part of the personal guarantee requirements of the lender. Since the guarantor is liable to pay for the loan, the first thing the lender will ask is for personal information. KYC details will be collected, and the guarantor will be asked to state whether he/she has any other business interests other than the current business for which the loan is being taken.
The second scrutiny is on the creditworthiness of the guarantor. Lenders will check his financial records using the documents submitted. The credit score will be obtained and the ability of the guarantor to pay back the loan is determined.
In India according to the laws for done by RBI, Reserve Bank of India, these are the risks involved of being a personal guarantor for a business loan:
- A personal guarantor must keep a check on the business’s loan repayment
- A personal guarantor is personally liable to pay off the loan.
- A personal guarantor cannot part from the company without permission or knowledge of the lender.
Rules to be followed by a business while deciding a personal guarantor
These are the rules published by RBI regarding the requirement of personal guarantor for business loan sanctioned by financial institutions in India:
- When the lending institution is satisfied about the management, its stake in the concern, economic viability of the proposal and the financial position and capacity for cash generation of a public limited company then it need not offer a personal guarantee
- When the lending institution is satisfied about the management, its stake in the concern, economic viability of the proposal and the financial position and capacity for cash generation of a widely owned public limited company then guarantees may not be necessary even if the loan is unsecured.
- Personal guarantee is required for companies (whether private or public) where shares are held closely by a person or connected persons or a group. Here the guarantee should preferably be signed by the principal members of the group holding shares in the borrowing company rather than that of the director/managerial personnel functioning as director or in any managerial capacity.
- Personal guarantees are necessary when the balance sheet or financial statement of a company is merged with the accounts of other concerns owned or managed by the same group.
Being a personal guarantor is risky for any business owner. In case the guarantor is not able to pay off the loan in case default by the business his/her credit score will be drastically reduced. He/she will be unable to secure a personal loan in this case. Therefore, make sure you consider the company’s financial viability carefully before you agree to becoming a personal guarantor.