Personal Guaranties

A personal guarantee places all personal assets and future earnings of the incorporated small business owner at risk in loan default. Once an incorporated small business owner provides a personal guarantee for a loan, the lender has effectively pierced the owner's limited liability protection gained through incorporating the business entity. This loss of limited liability protection provides the lender a legal recourse to satisfy the loan with the personal assets (net worth) and future earnings, if necessary, of the incorporated small business owner. In case of loan default, the personal guarantee's execution places the lender in a control position over the incorporated small business owner's personal assets. Lambrecht found, as did Mann, that guarantees provided by the small business owner give the lender recourse against the small business owner for any deficiency in payment. The only way to eliminate the small business owner's personal liability on a loan with a personal guarantee is for the owner to file for personal bankruptcy or for the leader to agree to remove the personal guarantee requirement from the loan. 

Understanding the distinction between the incorporated small business's financial responsibilities and the incorporated small business owner's personal financial responsibilities is required. When an incorporated business entity enters into a loan with a lender without a personal guarantee, repayment is the total responsibility of the incorporated business entity. In a loan transaction without a personal guarantee, the loan is a two-party transaction between the incorporated small business and the lender. When a personal guarantee is required and provided in a loan transaction with an incorporated small business, it becomes a three-party transaction. The incorporated small business owner signing personally is the third party. In the third-party role, the incorporated small business owner is signing personally, separated from the incorporated small business owner signing as an officer of the corporation. In making the loan, the incorporated small business owner will sign for the business entity as an officer (President, Vice President, Secretary, or Treasurer) committing the business entity and sign a second time as an individual pledging his or her net worth and future earnings. 

A personal guarantee liability far exceeds the incorporated small business owner's liability when the lender for a loan requires only collateral, whether business or personally owned collateral. The collateral only loan does not allow the lender to pierce the limited liability protection provided by incorporating the small business entity unless the incorporated small business owner has provided a personal asset as collateral. In that case, the lender can only pierce the owner's limited liability to access the collateral in loan default. Duarte, Gama, and Gulamhussen found, "collateral removes the downside risk for owners while preserving the upside potential". 

In those circumstances, the lender can only take possession of the personal assets explicitly pledged as collateral. Collateral only loan default results in the surrender of the collateral to the lender. The incorporated small business owner has capped the risk of loss at the pledged collateral value in a collateral only loan. The credit rating on the incorporated small business may be diminished due to the default. However, the incorporated small business owner's personal assets and future earnings are not at risk other than the pledged collateral. After proceeds from the collateral sale or liquidation have been applied to the loan, any remaining loan balance is the lender's loss. 

To avoid or minimize any loss due to default, lenders often require both collateral (if available) and a personal guarantee. Requiring a personal guarantee along with business or personal collateral allows the lender to minimize any loss incurred through the sale of the collateral. This loan arrangement makes incorporated small business owners financially responsible for any remaining loan balance after the collateral sale or liquidation. This loan arrangement could deter the lender from working diligently to maximize the collateral sale proceeds because the lender has access to liquidate the incorporated small business owner's personal assets as expediently as possible to satisfy the loan balance. 

Guaranties are essentially a contract among three parties: a creditor, a debtor, and a guarantor who promises to perform or pay damages on the debtor's behalf. When providing a personal guarantee, the incorporated small business owner has entered into the relationship (loan) as two separate entities: the debtor and the guarantor.

"Guarantee" vs. "Guaranty"

There is no essential difference between "guarantee" and "guaranty" other than the spelling. Financial scholars use the word "guarantee," while legal scholars use the word "guaranty." The word "guarantee" will be used throughout this document even when addressing the works of legal scholars such as Mann and Katz, who used the word "guaranty".

Background

Steijvers and Voordeckers found that, since Ang, Lin, and Tyler, the use of the personal guarantee continues to be overlooked, understudied, and, in general, misunderstood in the field of finance. Steijvers and Voordeckers identified that some studies lump business and personal collateral together, while others address business and personal collateral separately. Unfortunately, all of these prior studies have failed to distinguish between business collateral and personal commitments (personal collateral and personal guarantees). This failure is because personal commitments are not generally or routinely part of finance for publicly traded businesses, the subject of most financial data collection to date. Mann supposed that prior legal scholarship had not considered the landscape of small business lending, in which the personal guarantee is an essential factor because commercial law scholarship had also focused on the practices of large companies. 

While collateral used by large and small businesses has been the subject of many studies, personal guarantees are unique to small business lending. Prior studies' failure to distinguish between business collateral, personal collateral, and personal guarantees has likely contributed to the mixed results documented. Studies of risk-mitigating tools for loans that focus on collateral use by small businesses, but fail to distinguish between business collateral, personal collateral, and personal guarantees, should be reviewed to determine if this further delineation can explain the mixed or contradictory results. Prior mixed study results are possibly directly linked to the misunderstanding or omission of the personal guarantee's far-reaching impact. 

This research study includes a survey that poses questions that appertain to the demand for personal guarantees from the owners of incorporated small businesses, similar to the Federal Reserve Board's 1987 National Survey of Small Business Finances (NSSBF). Data collected will be compared to the results of the 1987 NSSBF to determine the trend in demand by lenders for personal guarantees from owners of incorporated small businesses over a 27-year period. 

During the 1980s and 1990s, the banking industry in the U.S. underwent significant changes. Mann links these banking sector changes beginning in the early 1990s with the banking industry's deregulation, allowing for interstate branching by individual banks. Interstate banking (branches of the same bank located and operating in multiple states) led to a period of significant merger and acquisition (M&A) activity during which information technology also experienced significant advancements. The banking industry began to find the small business lending sector much more attractive as a growth opportunity based on this new technology. The 1980s and 1990s catapulted the banking sector from an industry consisting of large state banks with many locally owned and operated smaller banks to an industry composed of national banks with branches in multiple states. This transition yielded a constantly decreasing presence of locally owned and operated banks, as the M&A activity continued. Black & Strahan (2002) found that the deregulation of U.S. banks during the early 1990s resulted in an increased presence of larger banks through M&A activity and increased competition. The growth of the banks with a national presence in the U.S., coupled with the advancement in information technology, led to an extremely competitive banking industry. 

In order to reduce transaction costs of processing small business loans and to determine the probability of the small business owners repaying the loan, banks exploited the use of the small business owner's personal credit information, which had become much less expensive to obtain as a result of advancements in the area of informatics. During the late 1980s, lenders began demanding personal guarantees more frequently. 

Avery, Bostic, and Samolyk, the second documented study to examine this lack of separation between business and personal risks of small business owners, found a 57% increase in the use of personal guarantees by owners of incorporated small businesses between 1987 and 1993. Mann challenged Avery et al.'s findings, maintaining the study had not captured the actual magnitude of the increase in the demand for personal guarantees. Mann found Avery et al. had included unincorporated businesses in the analysis, and this had allowed the actual percentage of incorporated businesses providing personal guarantees to be understated. Additionally, the 1993 NSSBF did not collect the source of any guarantees. Avery et al. had imputed the percentages of guarantees provided by the various sources and documented this in Footnote 14 of their paper. This calculation brings into question the validity of the findings of Avery et al..

Mann, not recognizing that Avery et al. had imputed the percentages of guarantees from the different sources, encouraged Avery et al. to continue their research while focusing only on incorporated business entities. A search conducted during 2014 did not identify any published article that accomplished what Mann had encouraged Avery et al. to do. During the literature search, Cole surfaced for its research on personal guarantees. Cole used the 1987 and 1993 NSSBF, and the 1998 and 2003 Survey of Small Business Finances (SSBF) to study capital structures of privately held U.S. firms. Cole used levels of leverage to conclude that incorporated businesses, which she found to be operating with higher leverage levels than unincorporated entities, must be doing so because the corporate firms had not provided personal guarantees. Mach and Wolken stated that many small business owners rely on personal assets to collateralize loans for their firms. Lambrecht suggested it could be beneficial to study the effect of personal guarantees on small business loans.

Theoretical Basis for the Research

While there are multiple research links to this study, two seminal works provide the foundation for the research: Leland and Pyle's "Informational asymmetries, financial structure, and financial intermediation", and Stiglitz and Weiss's "Credit rationing in markets with Imperfect information". "Information asymmetries" and "Credit rationing" have both been, and continue to be, extensively researched and are found to impact a small business' debt structure. 

Research indicates that information asymmetries (Leland & Pyle, 1977) are the major underlying issue impacting obtaining finances for small businesses. Credit rationing results from efforts to mitigate information asymmetries. Many times, matters that impact small business debt structure demonstrate linkage with information asymmetries. While collateral; banking relationships ; and shorter loan maturity periods have been identified as information asymmetry-reducing or mitigating tools, collateral has been more closely examined than these other risk-reducing tools. Bosse suggests that collateral, reputation, and relationships in banking have their unique benefits and that small businesses use a combination of these systematically. Duarte, Gama, and Esperanca found that market concentration increases "lazy" bank behavior as banks request collateral to reduce screening efforts and not mitigate risk. Collateral has been used to mitigate the asymmetric information obstacle of small businesses for several decades and probably for multiple centuries.

The Problem Statement

Owners of incorporated small businesses have been, and continue to be, required to accept personal liability for loans extended to their incorporated small businesses. Mann identified that Avery et al. documented a 57.5% increase in the use of personal guarantees by owners of incorporated small businesses during the six years starting in 1987 through 1993, as evidenced by the 1987 and 1993 NSSBF data. Avery et al. imputed percentages of personal guarantees because the 1993 NSSBF did not collect the source of any guarantee. Additionally, neither the 1998 nor the 2003 SSBF collected data on the source of any guarantee. This study's primary focus is on lenders' demand for personal guarantees. Did lenders' demand for personal guarantees from owners of incorporated small businesses increase between 1987 and 2014?

Significance of the Study

Ang, Lin, and Tyler recognized that a lack of separation between business and personal risks has significant public policy implications addressing credit market access for small businesses. Wu and Zeng identified that a dynamic and healthy Small and Medium-Sized Enterprise (SME) sector is vital to developed and developing industrialized countries. Ang et al., building on Bernanke and Lown findings, suggested that the demand for personal commitments may help explain why some business owners with little or no personal assets have a higher probability of experiencing credit rationing. Gama and Duarte find that personal collateral may be a more effective signaling indicator than business owned collateral. Tirelli points out that small businesses are not required to have audited financial statements, which contributes to small incorporated businesses' opaqueness. The small business industry's importance in any nation's economy is well documented. The U.S. House of Representatives House Committee on Small Business issued an update to its Small Business Fact Sheet on May 21, 2013. In this document, the Committee provided the following information: 

1. There are an estimated 27 million small businesses (generally described as an independent company with fewer than 500 employees). 
2. Small businesses employ about half of all private-sector employees while creating more than half of the nonfarm private gross domestic product. 
3. Small businesses are responsible for having generated 65% of new jobs over the past 17 years.
4. Small businesses that have been in business for three and five years, which represent less than 1% of all companies, are referred to as "gazelle" firms. "Gazelle" firms, while comprising less than 1% of all companies in the U.S., generate approximately 10% of new jobs every year. 
5. Small businesses help fuel the U.S. economy by generating patents at 16.5 times the rate of large firms. 

Both the U.S. Senate and the House of Representatives recognize the importance of small businesses to the U.S. economy and job creation. For example, on March 16, 2014, 137 bills were pending in either the House of Representatives or the Senate focused on assisting small businesses (e.g., Accelerate Our Startups Act, Growing Small Business Act, or Small Business Investment Act). 

Ang et al. identified four potential policy implications. First, an underinvestment issue could exist if risk-averse small business owners decide to forego positive net present value projects because they do not want to place their personal assets and wealth at risk. Second, if some owners are more willing to provide personal commitments, then owners who cannot provide personal commitments may be credit rationed. Third, the availability of personal commitments may diminish or mitigate the adverse impact of asymmetric information between small business owners and lenders. Fourth, finance theory, including capital structure, agency costs, risk aversion, and bankruptcy, may need to be reassessed as they pertain to small business. 

No one can overemphasize the importance of capital. Modigliani and Miller declared that companies should maximize their capital structure's debt element to exploit the tax advantage realized through interest expense deductibility. Myers explained why it is rational for firms to limit borrowing even though they can gain a tax advantage. Gamba and Triantis determined, through a survey of American and European CFOs, that the most crucial driver of a firm's capital structure decisions is the desire to have and maintain financial flexibility. 

Being required to provide more collateral than is needed to ensure full repayment to the lender in case of loan default is a de facto borrowing constraint placed upon small business owners who may not be able to take a positive net present value project in the future due to the constraining nature of an over-collateralized prior loan. Carbo-Valverde, Rodriguez-Fernandez, and Udell  provided that financial constraints restrict firms' ability to pursue investment opportunities. Scherr and Hulburt found that small companies differ from each other in fundamental respects that influence the choice between short- and long-term debt financing. 

Avery et al. found that if personal commitments are prerequisites for obtaining credit for small businesses, the small business owner's wealth will play a vital key role in determining the allocation of credit to small firms and their ultimate survival. These researchers raised the possibility that if personal commitments are prerequisites for small business lending, many small businesses may not appear as financial entities that are entirely separate from their owners. Avery et al., and Cavalluzzo and Wolken pointed out that if the personal wealth of the small business owner is critical to underwriting decisions, then owners who lack the resources to provide personal, financial commitments may find themselves unable to secure a small business loan. Avery et al. found any change in credit flow to small businesses may result in potentially significant economic consequences. Locking out a financial inflow to a small business, based solely on the small business owner's inability to provide credible personal commitments, may negatively destroy a business concern that could provide more employment and other social benefits to society. Cavalluzzo and Wolken and Blanchflower, Levine, and Zimmerman suggested there exists a potential for discrimination in lending decisions against certain demographic groups.

The paper will proceed as follows. Section II will outline the research methodology, provide the research question, and describe the survey instrument. Section III will report the results and summarize the findings. Section IV will conclude the study, discuss limitations, offer an update since the completion of this study, and suggestions for future research.