Personal guarantee loans for SMEs: A symptom of trouble

According to the Purbeck Personal Guarantee Insurance Monitor, there has been a 49 per cent year-on-year rise in small business owners using personal guarantees for small business loans. 

Purbeck reported that 37 per cent of these loans are for working capital, or simply to keep their business running. And it’s not just the number of personal guarantee-backed loans that are increasing. So, too, is the average amount, with commitments rising by 11 per cent to £157,285 in Q1 2024 from £141,264 in Q1 2023, the report states.

Dr Samar Gad, Associate Professor and Course Director BSc Accounting and Finance at Kingston Business School, says these figures are a symptom of a wider problem in the SME business environment.

Q What do these figures tell you about the plight of SMEs?

Dr Samar Gad: It indicates that lenders are becoming more risk-averse due to the current uncertainty related to interest rate adjustments and businesses' ability to repay debt amid the ongoing recovery from the pandemic and economic downturns. 

In other words, this high percentage of personal guarantees may indicate difficulties for businesses in securing traditional financing without additional personal risk from directors, which could be viewed as a red flag suggesting financial instability or a high-risk environment. 

Q Where does the risk lie for those guaranteeing the loans, and how might this affect decision-making in business?

Gad: Personal guarantees can provide necessary capital, but they also increase financial risk to directors personally. If the business fails to meet its loan obligations, directors could lose personal assets, impacting their decision-making. This could lead them to be more conservative in business ventures or, conversely, motivate them to pursue aggressive growth to ensure financial stability and safeguard their assets.

At the market level, a high percentage of personal guarantees could prompt investors and analysts to reassess the risk profile of their investments. While potentially impacting investor confidence negatively if perceived as a sign of weakness, it can also reflect strong personal commitment by directors, which may be viewed positively in terms of leadership and accountability.

Q Are there specific outcomes you expect to see as a result of this proportion of lending from personal guarantees? Should we expect a greater number of insolvencies, for example?

Gad: The immediate effect of securing a loan through personal guarantees is often positive for liquidity, as it provides the company with the necessary cash flow to cover short-term financial obligations and operational costs. 

However, the long-term impact on liquidity could be negative if the additional debt service requirements – interest and principal repayments – drain cash resources that could otherwise be used for operational needs or growth investments. 

For example, enhanced liquidity can enable a company to invest in marketing, inventory or new projects, potentially boosting revenue turnover. On the flip side, if loan funds are primarily used to service existing debt or for non-productive purposes, there might be little to no positive impact on business solvency in the long run. 

Additionally, if the market perceives the company as risky due to the heavy use of personal guarantees, it could impact customer and supplier confidence, potentially harming profits.

Q How might real or potential investors view personally guaranteed loans in terms of the perceived value of the business?

Gad: The use of personal guarantees might affect equity valuation in several ways. Initially, it might boost confidence among investors due to the directors' commitment to the company. 

However, the associated increased risk profile might lead to a valuation discount, as the risk of personal financial distress for directors could deter investment, fearing potential instability or misaligned priorities between managing directors’ personal risk and company growth.

Q Might such loans affect credit ratings?

Gad: For the business credit rating, in the short term, personal guarantees may not directly affect a company’s credit rating as the guarantees are personal and do not initially alter the company's fundamental creditworthiness. 

However, over time, if the company becomes heavily reliant on debt secured through personal guarantees, it might signal underlying financial weakness, potentially leading to a credit downgrade. 

Moreover, any impact on the directors' personal credit scores, due to defaults or the financial strain of the guarantees, could indirectly affect the company's credit negotiations and terms in the future.

Q What conversations should accountants be having with their clients?

Gad: There are key flags that accountants should raise with their clients before directors sign personal guarantees:

1. Personal guarantees expose directors' personal assets, such as homes, savings, and other valuable assets, to risk if the company fails to meet its loan obligations.
2. If the business defaults, it could adversely affect the director's personal credit score, making it difficult to secure personal loans, mortgages, or other forms of personal credit in the future.
3. Failure to fulfil a personal guarantee can lead to lawsuits and asset seizure.
4. Personal guarantees might limit future financing options for both the business and the directors personally, as ongoing liabilities may deter new lenders.

Additionally, accountants should:

• Understand the directors' risk tolerance and long-term business goals to advise on a conservative (surviving) or aggressive (thriving) approach.
• Discuss the current financial health of the company and future projections to evaluate if the business can sustain growth-oriented investments or should focus on stabilising.
• Engage in scenario planning to show potential outcomes of different strategies, such as the impact of leveraging with personal guarantees under various economic conditions.
• Encourage a balance between meeting short-term financial needs and maintaining long-term business viability, highlighting strategies that avoid over-leveraging.
• Discuss alternative sources of financing that might avoid the need for personal guarantees, such as angel investors, venture capital, or government grants and loans.
• Advise on the importance of regularly reviewing financial strategies and adjusting approaches as market and business conditions change.