Personal Guaranties

Posted on May 13, 2012

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Takeaways:

  • Banks almost always require personal guaranties.
  • Personal guaranties pierce the corporate veil; if you have signed a personal guaranty, you have personal exposure to the extent of such guaranty.
  • If one shareholder or partners has entered into a guaranty and the others have not, then the shareholders or partners should enter into contribution agreements in order to have a right against the non guarantying shareholders or partners in the event of a default.

When I did one of my first entrepreneurial ventures, I went to the bank to obtain a loan so that I would not have to pull from my personal finances at every stage. My banker treated me to a nice lunch and asked very politely about my plans and my expectations. We went through my budget and my business plan, and he provided meaningful and insightful feedback. At the end, as we began negotiating the actual terms of the loan, he told me that he was going to have to have a personal guaranty and have the loan secured with stocks held in a separate account. I knew that this was coming, so I was not shocked, but I pushed him a little bit on our earlier conversation, to which he replied “Well, that is all well and good, but really what we are looking for is loan to asset value.” This was a telling comment because while he was quite polite about it, I was left with the impression that our lunch conversation could have just as easily been about my business venture at the slot machines of Las Vegas.1

The point here is that when it comes to bank debt, the bank has to be assured that they are going to get their money back. The cost of bank debt is traditionally less than 10%.2 Bank debt is the least expensive form of capital. Accordingly, if you are looking at capital sources simply from an economic perspective, the bank is almost always the best place to get capital. However, the reason that the bank is the least expensive in terms of percent of return is because typically they can take on the least amount of risk.

An essential tenet in banking is that they cannot write off debt. If a bank makes 20 loans at $100,000 a piece at 5% interest, then it will make $100,000 in a year. (Five percent interest equals $5,000 over 20 loans equals $100,000.) However, if just one of those loans goes bad and is written off, they will make no money. Obviously that is not sustainable, so they have to be sure that all of the principal of the loans are paid off. In order to lend at a low rate, they must be certain that they are going to be paid back. On the scale of capital, traditional bank debt is the cheapest capital, so accordingly the bank will take the least amount of risk.

Additionally, they are going to have to be sure that if things go bad or wrong with the business they are going to get repaid. A bank reviews whether it makes a loan by focusing on what it can get for the assets in a liquidation process. You may have a piece of equipment for which you paid $100. However, if the bank can only get $50 from it when they wind down your business, then they are going to value that equipment at $50. At the end of the day, all of this is going to lead a bank to ask you for your personal guaranty. By signing this personal guaranty, you are going to insure that the bank is going to be repaid from your personal assets.

An important premise in dealing with personal guaranties is that they automatically pierce the corporate veil. While a good deal of liability protection exists with the corporate veil, and while liability protection is a legitimate reason to incorporate, the guaranty is personal liability. The bottom line on guaranties is that the bank or any other creditor can, and usually do, go after all of your personal assets (house, car, etc.) if you have signed a personal guaranty. Be prepared and know your exposure ahead of time.

Additionally banks, even if they are secure with the assets in the business, often require a personal guaranty regardless of security (or over security). Their reasoning is that if the business needs to be wound down, then they want the business operator to be cooperative in the winding down of such a business. This will maximize the liquidation assets of the business and allow the bank to recoup more money. This rationale is logical, and while you may be able to negotiate a way based on a risk analysis of the loss, typically a bank is going to prevail in the small business context. Your willingness to help wind down the company and your willingness to help when the business deteriorates will allow the bank to recoup more of its loss, and thus the bank can give (somewhat) higher value to the assets increasing the loan to value. (Remember, the bank is always thinking about protecting their downside.) In order to prevail on a discussion with respect to guaranties, you have to convince the creditor that they have the security or collateral that they could recoup the loan amount, and in order to do this, you have to have the capital in the business to make the bank secure in the collection of their principle.

Other vendors, suppliers, creditors and landlords under the same rationale will want to have businesses, particularly new ventures, guaranty the debt as well. The same counter arguments can be used and because they need the business (or may lose it to a competitor), these third parties relent on the guaranty. The warnings are the same — personal exposure. In particular with landlords, this exposure is not trivial. Also as a general word of warning, reading credit applications for vendors is extremely important (for you and your staff) as the application often contains guaranties of debt. These look like routine documents, but they are wolves in sheep’s clothing.

An adverse side effect of a guaranty is that unless each shareholder guaranties a debt, then a disalignment of interest occurs. One shareholder has more exposure than another shareholder, and this exposure is personal — above and beyond the corporate guaranty. Of course, putting more people on a guaranty is not wise; you should not give a guaranty unless you are required to give a guaranty. One workaround is to enter into a contribution agreement among the shareholders which requires a shareholder to contribute a pro rata amount in the event of a default. It is important to note that as a matter of corporate or contractual law, you need to have a separate agreement in order to have the shareholders or partners make such a contribution; a right of contribution among shareholders or partners is not automatic.

All of this points to a more challenging aspect of entrepreneurialism — increased personal exposure. It is extremely difficult to capitalize a business and start a business without a good deal of personal exposure. Company owners can, and often do, take outside investment at a higher cost of capital in order to decrease their personal exposure. I do not disagree. However, being a business owner increases your personal risk, and it is difficult to get around this.

Mike Goodrich
Goodrich Firm, LLC

1 For this particular business going to Vegas would have been a potentially more profitable effort.
2 See Cost of Capital.

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