Most merchant account providers require the owner(s) to sign a personal guarantee prior to the approval of the account for credit card acceptance. However, some owners are reluctant to sign a personal guarantee. After all, that’s one of the core reasons a legal entity was established in the first place – to give protection to individuals in the organization from being subject to the company’s liabilities.
Most providers will waive this personal guarantee requirement if one of the following conditions is met:
a) The company is public
b) The organization is a registered 501c3 or 501c4
c) The company’s financials are enough to satisfy the underwriters’ concern about the associated risk
Where is the risk? Fundamentally, a merchant account provider is at risk for every dollar that passes through the merchant account within a 6 month period.
Consider the following risk scenario:
An electronic company offers a new gadget for sale at USD 20. During the first wave of distribution, the company generates over USD 100,000 sales, and so everybody in the company is excited. To try and build upon the momentum, the company decides to spend all of their cash (sales generated) on a digital advertising campaign. A few days later, the company finds out that all the gadgets sold are defective and replacements are needed. But the fact that all of their cash is spent on the advertising, the company is not capable to give the replacement; so, they tell customers that they are sorry, and that they’re not able to honor the replacement included in the warranty agreement. With that, the cardholders (who have bought those gadgets) call their banks to initiate a chargeback, which is a formal dispute process. The merchant account provider then unsuccessfully try to debit the electronic company’s bank account for the disputed amount to cover the loss. At that point, the merchant account provider is financially responsible to refund all those customers who have bought the gadget and then disputed the charge with their bank.
From the scenario above, it’s clear that merchant account providers face this risk with each product or item sold, including services, software, memberships, consulting, and anything else that is bought through a credit card. Thus, when a merchant account underwriter makes a review of an account, they try to assess the risk associated with that account. Such risk assessment is done based on several factors such as merchants projected sales, the product or service being sold, company history, company financials and owner(s) credit. The exposure window for credit card transactions is six months (or up to 18 months in special circumstances), which is the duration a cardholder technically has to dispute a chargeback. This is also the reason why annual billing and lifetime memberships present underwriting and risk challenges.
The above risk scenario is an example of an honest mistake. However, merchant account providers are also aware of classic merchant account fraud – set up a merchant account, sell a bunch of goods and services, receive the money within 2-3 days, and then pack it up and skip town sans the delivery of items or services that were sold. In the absence of personal guarantee, the business can declare bankruptcy and the owners would be protected from any consequence. The personal guarantee is primarily used as a deterrent to prevent the associated risk involving the given scenario.
Businesses can provide financials to eliminate the personal guarantee requirement. A company’s financials need to demonstrate that they have the financial wherewithal to sustain losses or to absorb the impact of such losses that may occur.
And, merchants can always ask for exceptions and underwriters may or may not grant them. There are alternative arrangements that underwriters occasionally propose as a substitute of a personal guarantee such as a fixed amount up front or a rolling reserve.
Lastly, merchants need to be very careful with providers that do not maintain the necessary amount of underwriting due diligence as it will most likely come back to bite them at the worst possible time.