From the Business of Business section of How You Can Avoid Legal Land Mines by Joseph S. Lyles (2003).

Steve, who was well educated and very bright, went into business wit ha couple of people who claimed to have the know-how to manufacture and sell small trailers, called tow dollies. Because they didn’t have the capital to expand the business past the very early stages, they talked Steve into providing the capital in the form of cash and bank loans that he personally guaranteed.

A personal guarantee is a written contract that binds the guarantor to pay bills created by another party, usually a business the guarantor owns. Banks and suppliers typically require partners or corporate owners to sign guarantees for loans or credit to their businesses.

Unfortunately, Steve relied completely on what he was told by these persuasive entrepreneurs. He didn’t receive any independent advice on limiting his risk or protecting his interest in the venture. He was an easy victim of mismanagement or fraud by his partners.

After a year, and a few tow dollies later, the business collapsed and left Steve holding the bag to the tune of half million dollars in bank debt. Steve didn’t have any of the financial records of the company, and the entrepreneurs claimed the records were lost. He had stepped onto a legal land mine.

When Steve finally did consult a lawyer, all the assets of the company were gone, and the one company document he had received from his partners did not even create the legal entity Steve thought it had.

Steve was left with the difficult decision of whether to bring an expensive lawsuit against his former partners, who had few ready assets, and one of whom had filed for bankruptcy. Because there were no documents, the trial would have boiled down to a swearing contest. And, if he did win the swearing contest in court, all he would likely get would be a judgment for money. Judgments can be very hard to collect, especially if the person owns no equity in real estate to pursue.

The Lesson: In a business deal, relying on what someone else tells you can be an expensive mistake. Insist on written documentation of every aspect of the business. Carefully monitor how the money you invest is being spent.