While they are nothing new, personal guarantees have become more commonplace as tight credit conditions have forced banks to become increasingly conservative in their lending practices.
A personal guarantee (PG) is a note signed by a loan guarantor – business owner, partner, investor or family member – that pledges personal assets as collateral in addition to the business assets. In the event of a loan default, this signed note gives the lender the right to pursue personal assets like homes, bank accounts and valuables, sometimes even before the business assets have been liquidated.
As many of your small business clients have either faced or will face the prospect of signing a PG, you can help them develop a negotiating strategy. Areas you can help walk them through include the amount of personal risk they’re willing or able to take on, or the implications of signing a PG if they’re a partnership situation.
In that vein, here are some practical steps you can share with small business clients who have been told they’ll have to sign a PG:
Know what you’re signing. The terms of a PG can vary widely. In many instances, they allow lenders to pursue personal assets even if there isn’t an in outright default. Circumstances that could permit this include a technical default, additional borrowings, sale of assets, death or incapacitation. Some PGs even allow the lender to pursue additional collateral on demand if they believe the loan to be under-secured. Another misconception about PGs is that incorporation affords legal protection against a lender pursuing personal assets. In fact, signing the PG pierces the “corporate veil” and allows personal assets to be seized.
Know who you are signing with. When there are multiple partners involved, they often sign a “joint and several” PG agreement. While the logical conclusion is that this spreads risk out among the partners, in fact the lender is free to pursue whichever partners it wants – which generally means going after the ones with the most liquid assets first. This can lead to the difficult situation of having partners pursuing relief from the others on their own, as they’re often friends or relatives.
Define your terms in advance. These are important factors for your client to consider before pursuing the PG, which you as a trusted advisor can review with them. They should know the answers before ever entering the bank to ask about a loan:
• Am I willing to pay a higher interest rate in exchange for no PG or a limited PG?
• Would I consider borrowing less money?
• Would I be willing to put up a higher compensating balance for the money borrowed (which really translates into a higher interest rate)?
• Would I consider a shorter maturity date on the loan (after accounting for the added risk of higher monthly payments)?
Know what level of risk you can accept. Before approaching the bank, your client needs to determine their threshold of acceptable risk, both on a business and personal level. To do this they need to calculate the assets necessary to satisfy the PG should it be called, keeping in mind the fact that the assets of a challenged business will be worth much less than book value.
This is a particular area where you as a financial advisor can add value to your client. Help them evaluate the business’s liquidation value, taking into account any existing liens and the priority of repayment in case of bankruptcy.
Once the value of the business is estimated, your client should consider the amount of personal assets they can risk on the loan, including their equity in the business. What is an acceptable amount to gamble? The answer may be nothing; but whatever the number, it should be figured into the initial loan negotiation. The basic equation should be:
Liquidation Value of the Business + Acceptable Personal Risk > Personal Guarantee
Negotiate the terms of the guarantee. While nearly every term in the PG can be negotiated, it is important to help your client determine the points most critical to them, as well as those the lender is most sensitive to changing. Knowing this, you’ll be in a better position to help them shape their PG negotiating strategy. Possible avenues to consider include:
• Limit the guarantee: While banks will always want an unconditional or unlimited guarantee, the client should ask that the amount be limited either by the actual dollar amount or by a percent of the outstanding loan. If there are multiple owners, they could also seek to limit the amount of exposure by the percent ownership for each partner.
• Suggest terms of relief: For instance, they can ask to be relieved of the PG after a certain percent of the loan has been repaid.