If you are a significant shareholder or owner of a small to mid-sized business and are refinancing debt or a bank loan -- or leasing a facility or new equipment -- chances are that the lender or lessor will require you to sign a personal guarantee. For several years prior to the recent recession, credit was easy and it was possible to obtain a line of credit or lease new equipment or space without having to personally back-stop the liability. Not today. With rare exception for those businesses with extraordinary financial strength, obtaining credit of almost any type for emerging growth or middle-market businesses (i.e., those from start-up through $100 million in sales), will require guarantees by the owners with 20 percent or more of the equity in a company. This means that you need to be prepared to come out of your own pocket if your company no longer can make the scheduled debt payments.
So, how do you manage the risk and mitigate the liability associated with these personal guarantees? Developing an effective strategy for structuring and managing the personal guarantee begins with understanding your lender's objectives and perspective. Start by asking the lender or lessor why they want the guarantee. Some may seek to assure you that, as a significant owner, you are tied to the business to increase their likelihood of being repaid (especially if things do not go as planned). In the case of a financially weak business, they may require additional collateral or assets to make the loan or lease.
Next, determine the maximum out-of-pocket amount that you are willing (or able) to actually pay if everything goes wrong and you must personally write a check. Knowing this amount will play into the terms and the amount that you should guarantee. As an example, some owners do not mind guaranteeing their company's debt, as long as they are never really at risk of loss. In other words, their worst case out-of-pocket amount is zero. You can accomplish this by assuring that the amount of debt guaranteed never exceeds the liquidation value of the assets of your business, taking into account the priority of liens and repayment if the business went bankrupt. If you are okay with taking some financial risk, then calculate the same liquidation value and add the acceptable amount. Once you have established a limit, have your controller, bookkeeper, or accountant provide a monthly or quarterly estimate of liquidation value based on your actual financial statements. This will provide you visibility so you can track and manage the risk being taken.
If you are in a position to shape the deal, use the information above when negotiating the terms of the guarantee so they fit your situation and limits. Below are some of the key points that you should consider:
1. Guarantee of payment vs. guarantee of collection. The most common guarantee is that of payment. This means that if your company does not meet the agreed payments, the lender (or lessor) can demand payment directly from you as the guarantor without pursuing further action against the company. As the guarantor, you would rather be a guarantor of collection. This arrangement typically requires the lender (or lessor) to first exhaust its options against the company before it can demand payment from you. So, if you never allow your company to borrow more than the liquidation amount of its assets and you made a guarantee of collection, you could avoid ever having to write a check from your personal assets. Alternatively, you might seek to completely limit any risk unless you commit fraud in managing the business; this is sometimes referred to as a ﬁduciary guarantee.
2. Limit scope and collateral. Limit the scope of the guarantee to exclude recourse against your house or other specific property. In addition, do not agree up-front to liens against your property or a pledge of the stock in the business.
3. No spouse signature. Avoid having your spouse sign the guarantee, so that the guarantee is based solely on your assets. Be prepared to provide ﬁnancial statements showing only your individually owned assets and liabilities. In most states, this limits the risk to only assets held solely in your name, not joint assets or those of your spouse. So, if your house is owned with your spouse jointly (or just by your spouse) the laws in most states would prevent the lender from taking recourse against it.
4. Set limits. Quantify the limits on the amount of the guarantee, either in relative terms or absolute terms. For example, your company may have a line of credit with $2 million total availability. Seek to limit your exposure to 20 percent of the outstanding balance or a maximum of $200,000. This is particularly appropriate with multiple owners, whereby you may desire to limit your exposure based on your percentage ownership. Additionally, negotiate to reduce the guarantee as the performance of the company improves. As an example, your company has a debt-to-equity ratio of 3:1 post-ﬁnancing; seek agreement to reduce or limit your guarantee when the company's debt-to-equity ratio falls below 2:1. Also, consider having the guarantee become less onerous over time, based on the bank's continued relationship with your company. For example, a guarantee of payment could convert to a guarantee of collection after a couple years of a spotless repayment record, or the guarantee could burn off gradually.
5. Adequate insurance. Insure the supporting collateral for the loan or lease on a replacement cost with limits commensurate with the cost to replace the property. You do not want to find yourself caught off-guard in the event of theft or hazard and then obligated to personally pay for lost inventory or property that is part of the deal. Also, take the time to make sure your business interruption (business income and extra expense coverages) limits are in sync with the amount of time and additional expense it would take to restore normal operations after a disaster. In addition, consider fraud insurance to protect against an officer or employee stealing from the company and incurring debt on a line of credit. Broad form property insurance usually covers only a small amount unless specifically added to the policy. Increase this policy limit to match the credit facility limit.
From a practical perspective, guarantees are difficult to negotiate or to get much movement on unless the lender (or lessor) wants your company's business and unless there is competitive pressure giving you and your company the ability to haggle for improved terms. Negotiating these terms is done in the context of the overall credit facility or lease agreement at a time of change.
Lastly, get good, independent advice from experienced legal counsel and financial experts. If you have partners or other shareholders, you will likely want separate counsel representing you versus your company. The nuances of the guarantee are specific to you and your circumstances, so be sure to get qualified legal advice to assure the terms and concepts fit your situation.
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