In Tight Credit Market, 5 Keys to Negotiating a Personal Guarantee
In today's world, chances are that the lender or lessor will require owners and major shareholders of a small to midsize business to sign a personal guarantee during the refinancing debt or a bank loan, when leasing a facility or purchasing new equipment.
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 backstop 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 - 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.
Assess your situation: Start by asking the lender or lessor why the guarantee is wanted. Some may say to assure that you, as a significant owner, are tied to the business to increase the likelihood that the lender or lessor will be repaid (especially if things do not go as planned). Or additional collateral or assets may be required if your business is financially weak.
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 OK 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.
The 5 tips: If the company 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. Kenneth H. Marks, founder and a managing partner of High Rock Partners and lead author of the Handbook of Financing Growth, offers these 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 ?duciary 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 upfront 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% 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 of 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 postfinancing; 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 coverage) limits are in sync with the amount of time and additional expense required to restore normal operations after a disaster. In addition, consider fraud insurance to protect against an officer's or employee's 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 your company and you 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.
Finally, get good, independent advice from experienced legal counsel and financial experts. If you have partners or other shareholders, you will likely want you and your company to be represented by separate counsel. The nuances of the guarantee are specific to you and your circumstances, so get qualified legal advice to assure the terms and concepts fit your situation.
Edited from an article by Kenneth H. Marks, the founder and a managing partner of High Rock Partners, providing growth-transition leadership, advisory and investment services. He is the lead author of the Handbook of Financing Growth published by John Wiley & Sons (http://www.HandbookofFinancingGrowth.com). You can reach him at khmarks@HighRockPartners.com. The author gratefully acknowledges the assistance of Michael P. Saber, a Partner with Smith, Anderson, Blount, Dorsett, Mitchell & Jernigan, LLP, who can be reached at msaber@smithlaw.com.
