Essentially, a guarantor is someone who guarantees a loan or debt obligation for a company by offering their own assets as collateral. This means, in the case that the company can’t pay back the money they owe, the guarantor will do so for them out of their own means.
Why do businesses need guarantors?
Generally speaking, pretty much all small businesses have to personally guarantee their loans, particularly if they’re just starting out and don’t have enough credit history or assets to secure a loan. For example, a small business might have a letter of credit put in place, but the lender may not be confident in the business’s potential success. In that circumstance they might ask whoever is putting that letter of credit in place to personally guarantee that company.
A personal guarantee is also very common in bootstrapped businesses. Bootstrapped startups rely on a founder’s personal funds or revenue generated by the business itself, without seeking external funding from investors or VC funds. So that founder will often act as a guarantor.
However, here at Kruze, we actually encourage VC-backed startups and their founders to avoid personally guaranteeing their loans whenever possible. Not only are there many things that could go wrong, but VC-backed companies are always raising money and there will be much deeper pockets around the table than the company founder.
When should founders act as guarantors?
While generally founders should not be their own guarantors, there are exceptions. One is when a founder has had a really successful exit, for example, and is worth $50,000,000 to $100,000,000. A founder in this situation can probably afford to guarantee a loan. However, In this circumstance, they will probably want to cap/limit the guarantee. Essentially, they will want to negotiate the highest amount for which they’re willing to offer collateral.
Do venture capital funds ever act as guarantors?
Sometimes a VC firm may act as guarantor for a loan for a startup on the startup’s behalf. However, this is incredibly rare, and we’ve only seen it happen a handful of times.
Usually, the reason for this particular situation occurring will be that the VC fund is pretty short on cash itself. In conjunction with this, the company they are acting as a guarantor for will most likely just be reaching profitability, but is still in the process of getting over the ‘hump.’ Essentially, they don’t really need more capital from the VC fund but a little bit of debt could be helpful.
So, since the VC fund is short of cash and they don’t actually want to provide any equity right now, they could personally guarantee the loan from the bank, working on the basis that they’ll only have to provide said equity if they absolutely have to.
Like we’ve said, this is not a common occurrence at all. You would usually only ever see it with mature VC funds that don’t have a lot of liquidity but also don’t want this company to have to take more equity and get washed out.
Be careful about guaranteeing loans!
The main things to remember regarding loans and their guarantors are:
- We recommend that if you’re a founder you try to avoid personally guaranteeing a loan.
- If you are running a small business or a bootstrapped startup rather than a VC-backed startup, you are probably always going to have to personally guarantee a loan.
- Very, very occasionally a VC fund might actually act as a guarantor for a startup.
If you have any other questions on guarantors, valuations, startup investing, or startup accounting, please contact us. You can also follow our YouTube channel and our blog for information about accounting, finance, HR, and taxes for startups!
