In today’s tight credit market, banks have become much more stringent in their business lending requirements...
Every day, many small-to-medium-sized business (SMB) owners find themselves in need of new funding for all kinds of good reasons – working capital, business expansion, hiring and building additions, to name a few. For those without deep pockets, investors or ready cash from operations, this means seeking a loan.
But in today’s tight credit market, banks have become much more stringent in their business lending requirements – even for established businesses with good credit. This means lenders are much more likely to ask loan applicants to sign a personal guarantee as a condition of approval.
A personal guarantee (PG) requires a guarantor to use personal assets (homes, investments, savings accounts, etc.) to repay a loan if his/her business is unable. While terms vary, many personal guarantees allow the lender to go after these personal assets directly in the event of a loan default – even before the business assets have been liquidated.
Some SMB owners may think their business structure – Limited Liability Corporation (LLC), Subchapter-S Corporation, etc. – acts as a “shield” protecting their personal property by separating it from business assets. However, the PG is designed expressly to allow the lender to access personal assets to satisfy the debt obligations.
In order for CPAs to more effectively serve their SMB clients, here is a brief review of some of the existing personal guarantee obligations in the market today and options for limiting that risk.
The Personal Guarantee as Prenuptial Agreement
A PG acts much like a prenuptial agreement. Just as no one likes to think about divorce before they marry, a guarantor signing a PG often doesn’t fully consider the prospect of business failure when launching or growing it. However, the reality is both divorce and default are fairly common occurrences, and this risk needs to be taken into consideration upfront.
Since many business owners obtain a loan, sign a commercial lease, or enter into supply agreements without seeking counsel from their CPA, it is useful for them to advise their SMB clients early on about the implications of signing a PG. Otherwise, many end up signing one without realizing the ramifications.
Counseling SMB Clients on Personal Guarantees
Acting in an advisory capacity, a CPA can help clients seek the most favorable PG terms possible. One critical step you can take is to help your client quantify the extent of his/her personal risk tolerance before talking with a bank. First, the business owner should assess the market value of their business and then calculate the business’ estimated liquidation value. Next, the owner needs to determine the maximum out-of-pocket expense he or she is willing or able to bear. So a rough estimation of an owner’s PG “comfort level” would be liquidation value plus personal risk tolerance.
A CPA can also run through alternative loan structures the client could propose in exchange for limitations on, or elimination of, the PG. These may include providing additional collateral; accepting a higher interest rate or a higher compensating balance; borrowing less than originally intended; or asking for a shorter loan maturity period.
Negotiating a Personal Guarantee
Once the business owner starts talking to a lender, the owner has several negotiation options. First, it is important to understand why the lender is requiring the guarantee and at what point (company size, duration of relationship, etc.) they would no longer require one. It is also critical to make the negotiation of the PG part of the overall negotiation for the loan, instead of allowing the lender to leave it until all other terms are settled.
Generally speaking, business owners often don’t have a lot of leverage in PG negotiations, especially in a tight credit market. Second, when setting the terms of the guarantee, it is important for them to consider the following options:
● The amount of the PG
● A release based on the percentage of the loan paid
● A reduction in the guarantee amount as the performance of the business improves
● A reduction in PG amount over time
● A specific end date for the PG
● A limitation of the guarantee to, or excluding, specific personal collateral
● When the lender can exercise its rights under the guarantee
● What personal financial reporting can be required
In addition, if the business has multiple partners, it is important to consider whether a joint and several guarantee is appropriate or whether specific limitations on the guarantee liability for each partner would be preferable. It is of course always better to keep spouses from having to co-sign the guarantee. However, lenders will generally accept this only when the guarantor has sufficient assets to individually support the guarantee.
Another Option: Insuring a Personal Guarantee
If a PG cannot be avoided altogether, and the lender is not open to negotiating less burdensome terms, CPAs have an additional option they can present to their clients – insurance that protects against personal asset loss when a PG is called.
Personal guarantee insurance can cover a substantial portion of the net liability of the PG – that is, what is owed on the note after the business assets have been liquidated. Thus, business owners and other loan guarantors can have 100% of a venture’s upside potential while transferring a substantial portion of the downside risk. The insurance can also alleviate a great deal of the anxiety a client faces when hard-won assets like his house and investment accounts are exposed and retirement is at risk with a PG.
In today’s credit market, chances are business owners will come face-to-face with a PG if they seek a new loan or an extension on an existing borrowing relationship. Therefore, CPAs should continue to be proactive in educating their clients about the implications of a PG and the available options. Bringing PGs into the conversation with SMB clients early on can help them avoid major headaches and devastating losses down the road.