Personal Guaranties

Conclusion

An entrepreneur strives to determine and understand all risks for any project they are considering undertaking. Financial theory demands that an entrepreneur take on any positive net present value (NPV) project. To correctly assess the overall project risks, the entrepreneur must understand the additional risk assumed when providing a personal commitment (personal collateral or personal guarantee) to obtain a loan for a potential investment opportunity. The incorporated small business owner should consider all project risks when determining the discount rate for an NPV analysis. The requirement to provide a personal guarantee and or personal collateral creates additional risk for the owner on the project beyond the future cash flows' risk. 

The personal guarantee frequency makes it critical that both undergraduate and graduate students know the differences between business collateral and personal commitments. Business students need to understand the far-reaching loan default consequences when they provide personal commitments to obtain or secure funding for an incorporated small business. This study provides insight into the percentage of loans in 2014 that involve personal collateral and personal guarantees. 

Stiglitz and Weise (1981), in their seminal article on the use of collateral in bank loans, did not distinguish between collateral owned by the business and collateral owned personally by the owner. It was not until Ang et al. (1995) that researchers documented the lack of separation between the small business owner's business and personal risks. Mann (1998) provided the importance of distinguishing between incorporated (S and C corporations) and non-incorporated entities (sole proprietorships and partnerships) because personal guarantees only increase the risk of owners of incorporated small businesses. Non-incorporated entities do not have limited liability protection, and therefore, the owner of a non-incorporated entity is personally responsible for any liabilities of the business. Some Limited Liability Companies (LLCs) operate as non-incorporated entities. Some U.S. states allow LLCs to operate as either an incorporated or non-incorporated entity. 

Through personal interviews with a non-random small group of small business bankers, Mann (1997b) concluded, "To the extent small business lenders require secured credit, they do so largely for one significant benefit: secured credit allows small business lenders to obtain a credible commitment that borrowers will refrain from excessive future borrowing". Mann continues, "Secured credit provides little in the way of liquidation value because the assets of small businesses tend to have low liquidation values. Similarly, it does little to improve the borrower's incentives, because the lender can accomplish the same goal by taking a guarantee from the borrower's principal". Mann used these points to support his position that small business borrowing is unsecured even though this contrasts with Berger and Frame (2007) findings. Small business loans backed by a personal guarantee from the owner of an incorporated small business provide the lender access to the owner's net worth and future earnings, if necessary, to repay the personally guaranteed loan. The only personal assets not reachable by the lender are those personal assets used to secure other loans. Most jointly owned personal assets are also protected from the lender if the other joint owner(s) did not provide a personal guarantee for the defaulting loan. 

Capital and access to capital are essential. Modigliani and Miller (1958) declared that businesses should maximize the debt element of their capital structure fully to exploit the tax advantage realized through the deductibility of the interest expense, but at what risk? Again, entrepreneurs must have a thorough understanding of the risks associated with any loan the entrepreneur undertakes. 

This study documents that over 15% of incorporated small businesses with a minimum of at least one loan in 2014 have successfully negotiated away the requirement to provide personal guarantees by refusing to provide the guarantee. While the lender may decline the loan, this study documented that over 41% of the 15% of owners of incorporated small businesses who refuse to provide a personal guarantee when requested still received the loan from the same lender. 

Second, the findings of this study support the positions taken by previous researchers. This study confirmed the existence of a potential under investment issue suggested by Ang et al. (1995), as 12.5% of incorporated small businesses with at least one loan did not undertake positive net value projects because owners did not want to place their personal assets and wealth at risk. 

This study confirmed an additional implication raised by Ang et al. (1995) as 10.9% of corporations were credit rationed because of the owner's inability to meet the lender's personal guarantee requirements. This study documents that personal guarantees are prevalent in small business lending. While Cole (2013) concludes that owners of incorporated small business owners are not required to provide personal guarantees, this study's results indicate otherwise.

Conclusions Drawn from the Study

Personal guarantees are a factor in lending to privately held incorporated small businesses. Data shows for five loan types in place during 2014 – lines of credit, mortgages, equipment loans, vehicle loans, and other loans, personal guarantees were required for almost 50% of the loans. The presence of personal guarantees probably contributes to the inconsistencies of prior studies. Studies that focused on either or both business and personal collateral required for securing business loans without any recognition or consideration given to the presence of personal guarantees. 

The finding that only 37% of incorporated small businesses had any loans during 2014 documents that the United States small business sector has not recovered from the Great Recession. The 1987 NSSBF data identified 67% of incorporated small businesses had existing loans in 1987. This 45% decrease in the percentage of incorporated small businesses requires further research.

Limitations

Owners of incorporated small businesses must have a thorough understanding of the risks associated with borrowing money for their businesses. This study's researchers anticipate that the percentage of loans with personal guarantees is probably much higher than reflected by the data collected during this study. Two factors support the researchers' position. First, if an owner does not have an understanding of what constitutes a personal guarantee, the owner might not know was provided. Mann (1997b) raised the concern that many small business owners have relatively limited financial expertise. Mann believed that small business owners were probably ill-prepared to adequately assess the cost and benefits of various secured and unsecured transactions. He concluded that if this were the case, banks could require personal commitments from the owners because the borrowers would not evaluate those financial risks accurately in deciding whether to accept the lender's terms. When they can obtain the loan, they just accept the terms potentially without recognizing that they are providing a personal guarantee. After all, some will say, if one borrows money, one should pay it back. Mann's conclusion of small business owners' financial understanding may have contributed to an understatement of the percentage of loans during 2014 with personal guarantees. 

Second, Question 8 of the survey provided a choice of "Have this loan under other arrangements". For this analysis, these arrangements consist of loans without business collateral, personal collateral, or personal guarantee. This assumption would lead to a potential understatement of the percentage of loans with personal guarantees if these arrangements were not some form of a loan. 

Conducting future research on the demand for either business or personal collateral without also determining the presence of a personal guarantee for each specific loan distorts the research from the start. Failure to consider the presence of personal guarantees in past studies may have contributed to the mixed and sometimes contrasting findings of the individual studies. Based on the prevalence of personal guarantees in the lending process for incorporated small businesses, this study's researchers recommend incorporating some personal guarantees coverage in all undergraduate and graduate introductory level finance courses.

Update since This Study

Ang (2018) presents a corporate finance theory for the entrepreneurial firm. Ang defines an entrepreneurial firm as a firm with the potential to create significant wealth well beyond the owner's wealth. The wealth beyond the "wealth of the owner" is the wealth created for a new industry and, subsequently, the macro-economy. Ang points out that entrepreneurial firms' projects may generate an aggregate positive net present value (NPV) at the industry/economy-level while remaining negative for an extended time for the firm owner. Ang identifies three corporate finance models for financing firm projects with no positive cash flow projected over multiple periods. One of these models addresses the government subsidizing innovation with useful indicators since the pending project will benefit the whole economy. Ang does challenge this model's effectiveness, suggesting its success will rely heavily on the experience of the government workers selecting the projects to receive funding. The second model uses the traditional sources of equity investors outside the entrepreneur's friends and family. The third model proposes a debt arrangement taken on by the entrepreneur that does not require any principal or interest payments for some extended time. Should the government guarantee debt for a project with a projected disproportional macro-economic payoff? Maybe a fourth model should be added with combined aspects of the proposed models one and three with the government providing the guarantee for the entrepreneurial firm's debt. 

In a follow-up to its 2003 Small Business Survey, some Federal Reserve districts began in 2014 conducting coordinated small business credit surveys. Since 2014 the Federal Reserve has been conducting annual Small Business Credit Survey (SBCS) and issuing reports. By the issuance of its 2016 SBCS Report on Employer Firms in early 2017, the Federal Reserve had successfully coordinated the report between all twelve of its district banks. The 2016 report was the first report to collect consolidated data for personal guarantees and personal collateral. The 2016 SBCS Report on Employer Firms finds, "Personal assets and personal guarantees are commonly used to secure financing, even among larger firms." The 2017 report survey questionnaire separated the data elements of personal guarantees and personal assets. The 2020 SBCS Report on Employer Firms found, "a majority of firms with debt used a personal guarantee to secure their debt".

Recommendations for Future Research

Research is needed to identify tactics that should be taken by incorporated small business owners to avoid providing personal guarantees while still obtaining required loans. Every business owner should have a strategy to maximize the owner's understanding and identification of all business risks. Additionally, an incorporated small business owner should minimize any risk to the lowest possible level for the selected project. Minimizing risk for a project needs to include avoiding the use of personal guarantees whenever possible. One research recommendation is that other ongoing small business finance surveys incorporate the same or similar questions from this study. Other ongoing surveys include the Federal Reserve's ongoing previously mentioned efforts and the periodic survey accomplished by the National Federation of Independent Businesses (NFIB). The NFIB surveys are generally accomplished with the telephonic and written medium through the U.S. Postal Service and could yield different results based on the surveyor's opportunity to explain to the respondent what is meant by a personal guarantee. The data collected by the Federal Reserve through its annual Small Business Credit Surveys (SBCS) over the recent past years should aid researchers in better understanding debt in the small business environment. 

Future research of Question 8 of the survey choice of "Have this loan under other arrangements" could provide greater granularity of how some owners of incorporated small businesses are meeting their capital requirements. 

The low percentage (37%) of incorporated small businesses with a loan in 2014 indicates an underlying economic issue. Is the issuance of the 2010 Dodd-Frank Act contributing to this under- levered situation for incorporated small businesses? By the issuance of the Dodd-Frank Act, has the government eliminated all potential bank failure to the point that it is decimating small business lending? It is essential to focus on the relationship between Government (Federal, State, or Municipal), the lending institutions, and the entrepreneurs. There are links between each of the three entities that determine the risk each is willing to take. For example, due to the Great Recession, the Dodd-Frank Act has potentially placed restrictions on the lenders drawing funds through the Federal Reserve Discount Window. The Federal Government tightened requirements levied upon the lenders to reduce the risk of the occurrence of another Great Recession. The new requirements result in a change in the lenders' behavior as they adjust their operations to minimize their operational risk while maximizing their returns. This altered behavior by the lending institutions potentially led to a decrease in the percentage of incorporated small businesses with loans in 2014. While this study focused on personal guarantees, the low percentage of incorporated small businesses with loans in 2014 is a crucial observation worthy of future research.