Founder Liability - The hidden trap

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Founders have the odds stacked against them. While many founders dream of building the next successful “unicorn,” only a select few succeed. Beyond the steep rate of failure, when founders launch a new business, they take on a tremendous amount of personal financial risk. And, for a variety of reasons, founders aren’t fully aware of how exposed they really are.

Technology startups fail at greater rates than the general population of U.S. service-based (professional) small businesses. Startups are twice as likely to fail than to succeed, which is a sobering fact for most founders [1,2].

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Finding the hidden clause

Failure isn’t the only risk that founders take. When founder Eddie Lim sold his company, the business credit card debt was not top of mind. As he transferred the business to its new owners, he didn’t realize the potential risks of transferring a business credit card in an acquisition.

As Lim puts it: “One day, four months after the sale, both my wife's and my primary personal credit card stopped working, while we were traveling.” 

After digging deeper, Lim realized that several of the business credit cards he had transferred were pending payment, and they were still tied to him because of a personal guarantee. Those bills had not been paid and were delinquent, so the credit card company shut off his personal credit cards. 

This experience is not unusual

But to understand how this happened to Lim and thousands like him, let’s look at the terms of a personal guarantee.

How do personal guarantees work?

A personal guarantee is a commitment by the founder or other business leader to personally pay their business debt if the company is unable to. If a founder signs a personal guarantee and defaults on that loan, her personal credit score and assets could be affected. 

Personal guarantees are very common in small business financing. In fact, according to a 2018 Federal Reserve study, 86% of businesses used personal credit scores to obtain financing[3].

What are the personal implications?

Banks typically bury “personal liability” clauses in pages and pages of terms and conditions. That means that business leaders often won’t know that they’ve placed their personal assets on the line in exchange for business credit card financing.

To check this hypothesis, Brex signed up for business cards from banks like American Express Business Platinum, Chase Ink, and Capital One Spark. In each case, personal guarantees were buried among clauses at the end of credit card disclosures and account terms.

Below are part of the American Express Terms & Conditions. Note the red box for hidden, opaque language ascribing founder liability.

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Below, founder liability is broken down by liability type and card product [4].

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How is my credit score impacted? 

Looking at the cards mentioned above, you’ll notice an “application impact” from most. This comes from banks doing a “hard pull” on your credit, tying your personal credit to their underwriting decision. This means that simply applying for a credit card can also decrease personal credit scores by 5 points per application [8]. 

While a five-point decline on a good credit score may seem trivial, the consequences of delayed payment or default can be much more significant. For example, if a credit card isn’t paid on time, a founder with a near perfect credit score of 780 could see his/her credit score fall by over 100 points. In addition, late payments and collections can remain on personal credit reports for up to seven years.

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What is “Joint & Several Liability” ?

The American Express agreement also has the term “Joint and Several Liability.” This means that everyone signing the agreement is liable for the full amount owed, impacting you in two important ways. 

First, as soon as your card payment is due, the bank has the right to take the full amount owed from your personal bank account, even if the company has funds available. In addition, even if you have more than one personal guarantor—say you and your cofounder—the issuer can go after either guarantor for 100% of the amount owed.

All of this combined can have dire consequences for founders and business leaders. In fact, up to 60% of startup founders have paid $50,000+ in personal assets to pay off business debt. [4]

Many think this won't affect them

As we saw with Eddie Lim, founders and business leaders often don’t know how personal guarantees will affect them in the long run. However, sometimes personal guarantees do not only affect your long-term credit, but your ability to get credit at all—as your personal credit score is a key factor in the underwriting process

Leveling the playing field for founders 

Brex was born from a frustration with the financial status quo, and our cofounders know firsthand the roadblocks to acquiring credit. But it doesn’t have to be this way. Brex is leveling the playing field by offering a corporate card with no personal guarantee to tech, life sciences, and large ecommerce companies.

With an innovative underwriting model, Brex assesses companies based on factors that matter – like cash in the bank and activity in the business – to assess your approval and credit limit decision. In addition, we don’t ask for joint and several liability.  

In doing so, Brex ensures that founders and early employees are not putting their personal credit scores on the line during one of  the riskiest junctures in their lives—starting a company. This new face of credit ensures that founders have access to capital at the most crucial time, without the hidden clauses.

[1] U.S. Service Business data from U.S. Census Bureau.[2] Technology startup data failure rate based on startups that failed to return 1x< on venture financing per Kramer, B., & Patrick, M. (2014). Trends in terms of Venture Financings in Silicon Valley. (pp. 3-4). Mountainview: Fenwick & West LLP.[3] United States. Federal Reserve Board. (2018). 2017 Small Business Credit Survey; Report on Employer Firms; 2018 report. https://www.newyorkfed.org/smallbusiness/small-business-credit-survey-2017 [4] Tsosoie, C. (2017, April 17) Do Business Credit Cards Affect Your Personal Credit Score? https://www.nerdwallet.com/blog/credit-cards/qa-business-credit-cards-affect-personalcredit-score/, Credit Karma, Company Websites, Terms & Agreements [5] Brex early stage founders credit card switching data. Base population: founders who used credit cards before Brex. [6] Early stage founders, both Brex and non Brex, surveyed by Brex staff (N=30)[7] 3-month average for Brex early stage founders. [8] Credit Checks: How Credit Report Inquiries Affect Your Credit Score. (2018). https://www.myfico.com/credit-education/credit-checks/credit-report-inquiries/ [9] Can one Late Payment Affect My Credit Score?” Equifax Finance Blog, Equifax, 7 Feb. 2014, https://blog.equifax.com/credit/can-one-late-payment-affect-mycredit-score/ [10] Credit Report Q&A – Effects of Credit Missteps. (2018). https://www.myfico.com/credit-education/questions/credit-problem-comparison

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