The Predicament of Personal Guarantees For Business Credit

So you have your new corporation or LLC formed… great! Now the next task on your list might be to build credit for it, but how do you do that?

In many ways, building credit for a new business is much harder than building personal credit. With the latter, there are a plethora of entry-level cards for students and people with no credit history. Unfortunately, you will be unlikely to find starter cards like that for businesses.

Pre and Post Recession

Before the “Great Recession” it was possible for new businesses to get a credit card without any sort of personal guarantee. Advanta, who was the second largest biz card issuer in the US, offered low-limit cards to new corporations and LLCs. But they went bankrupt and no other major bank has followed in their footsteps.

These days, when you apply for a small business credit card, almost every bank will require you to sign a personal guarantee. This means you will be held personally liable for the account.

For example, if you opened up the business version of a Capital One card, it would be treated exactly the same as a personal version in the eyes of the creditor. That means if you default on the account, Capital One would have the same collection rights and that delinquency would show up on your personal credit report. Ouch!

Is it worth the risk?

Of course as we all know, entrepreneurship in and of itself is synonymous with risk. So a personal guarantee certainly isn’t the only financial risk that goes along with starting a new business! But there are still three important things to consider before you plunge into a personally guaranteed line of credit.

1. If you have business partners, be extra cautious

It’s one thing to personally guarantee your own spending, but if there are partners involved who also own equity in the company, then you are also guaranteeing their spending on the account, too. Is that a risk you’re willing to take?

If your partner(s) have a bad credit history, that alone should be a red flag that it might not be the best idea to risk your credit for their spending. And even if they co-sign the guarantee, that risk would not be equal. After all, if things fall apart they don’t have much to lose since their credit is already bad. You on the other hand may have everything to lose if you have an excellent credit history that’s on the line.

Now if your partner(s) have a credit history comparable to yours, then the risk is more equally aligned.

2. While harder to get, there are other options

The one nice thing about personal guarantees is that they allow you to get an unsecured credit card for your brand new business. Without the guarantee that won’t be possible, but there are still other ways you can work on building credit.

One option is a secured loan, which basically operates how a secured card works (unfortunately there aren’t secured credit cards for businesses). The company puts forth a security deposit with a lender and then borrows against it. For example, a $10,000 deposit would be put up to get a $10,000 line of credit. Since you’re essentially borrowing money from yourself, this technique is rather useless for borrowing working capital. However if the goal is to just build credit, this approach is a great choice.

Another option is seeking out local vendors who are more inclined to offer unsecured credit in order to sell their merchandise to you. Forget the big chain stores like Office Depot and Staples because they require $5 million in annual sales before they will extend credit without a personal guarantee. However, you will find that many local and regional supplies are more open to giving new businesses a chance.

3. Personal guarantees are more risky with speculative industries

Of course every business is speculative to some degree, but some are really speculative. If your company has zero revenue and no foreseeable revenue in the near future, then it’s going to be even more risky for you to personally guarantee the credit. For example, a biotech startup might not have revenue for years and future funding from outside investors is uncertain. That’s a type of situation where the risk will be even higher than normal.

Meanwhile there are plenty of other industries like restaurants which may have a high a rate of failure, but at least they can generate revenue almost immediately (which can help to service debt). Being in a situation like that, where at least some revenue is coming in, is arguably less risky than a company who has no foreseeable future of any revenue.

The bottom line: it’s a decision to not be taken lightly!

Just like anything in life, there are both pros and cons that go along with personal guarantees. Just make sure you thoroughly consider the cons before you sign on the dotted line!

This guest post was written by Thaddeus Ackermann.