Personal Guarantees – When Necessary and How to Manage

Source: Federal National Commercial Credit blog

Most small business lenders, whether they are banks, asset based lenders, or invoice factors, require some form of personal guaranty from the owners and/or executives of the borrowing company.  I find it is one of the most common new borrower objections.  But it is surprising how many borrowers misunderstand the way guaranties work and why so many lenders require them.  Here are some of the important common misunderstandings and some thoughts about them:

My Personal Balance Sheet is Not that Strong

Question: Why would a lender insist on a personal guaranty if I don’t have the personal balance sheet to cover the loan?

Answer: Most reputable lenders have no, nada, zero, zip… interest in acting upon a personal guaranty and, in the overwhelming majority of cases, never need to.  The guaranty prompts thoughts about your confidence in the business, and the responsibility to repay. A lender will never know as much about the business and its assets as you do. If you do not have enough confidence in the quality of your business assets to sign a guaranty, how can you expect a lender to take comfort?  Even when things take a turn for the worse, most lenders will not turn to the guaranty.  Lenders view it as a sort of insurance policy that you will hang tough and help them work through the problem … not just walk away.  So it is less about making you pay and more about a contract of commitment and support.

They Already have all my Business Assets and this a Business Loan

Question: Why do they need this?  They already have all of my most valuable assets?

Answer: Again, a lender will never know as much about the quality of your assets as you do.  Though many lenders like to talk about being your business “partner” and the better ones do bring good business skills and counsel to your business, they are not investors or true partners.  They do not stand to benefit as much when the business does very well, and consequently, they do not expect to suffer as greatly if the business does not do well. Lenders want your interests closely aligned with their own.  If you have signed a guaranty, they feel like you will take extra care to be sure any assets they are lending against are indeed good assets.

I Can’t Allow a Lender to Just Decide to Take my Family’s Home

Question: Why would I risk my family’s home so a lender can have a guaranty?

Answer: Signing a personal guaranty does not enable a lender to just decide to foreclose on your house.  In fact, on its own it gives them no rights to unilaterally seize any of your personal assets.  If a lender holding your guaranty believes they have right to action under the guaranty, unless you agree to their claims, they must obtain a judgment in a court of proper jurisdiction first.  If you believe their claim is inappropriate, you would have opportunity to legally challenge their claim.  Even if the lender obtains a judgment, they may not be able to foreclose on your home.  That may depend upon the Homestead and Community Property laws of your state.

Some lenders, but certainly not all, also require you allow a mortgage lien or “deed of trust” upon your home if there is equity in it.  A deed of trust would allow a lender to foreclose without going through the legal process of obtaining a judgment in the event of a default.  However, just a guaranty alone does not grant the lender this right.

I Only Own a Small Amount of the Company.

Question: Why would I put my personal assets at risk to benefit the outside shareholders?

Answer: The active executives of the company are in the best position to prevent the lender’s financial loss.  Outside owners may be valuable guarantors if they have big balance sheets but most lenders want the assets to be strong enough that they never have to look to the guaranty.  The executives or managers are in the best position to insure that.

Sometimes, when executives only have a small interest, lenders may agree to use a Validity Guaranty instead of a Personal Guaranty.  Sometimes called a “Fraud Guaranty”, with a Validity Guaranty, you would warranty the quality of the collateral assets.  The most important difference would occur if your customer could not, or simply would not, pay your bills.  Under a Personal Guaranty, you would be personally responsible for this kind of lender loss. Under a Validity guaranty, you would likely not be liable for this kind of lender loss.

Mostly, lenders are looking for your diligence and honesty here.  The most frequent cause of significant financial loss among commercial finance companies is some form of fraud. Executives are the best line of defense against a fraud loss.

In some cases where the managers are not significant shareholders, some lenders may agree to waive the requirement of any guaranty. When this is done, it is usually because the circumstances offer some alternative strength.  Following are some examples:

  1. The borrower and their customers are fairly large and financially strong with excellent financial reporting capability and a good track record.
  2. The lender has a particular expertise in the business and feels that gives them enough comfort without the guaranty.
  3. Special structural terms may be added to help them reduce their risk in other ways. For example, the lender may seek communication from the borrower’s customers that validates the quality of invoice assets used as collateral.

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