A guarantee, at its most basic form, is a promise made by one party to fulfill an obligation of another party. Guarantees are frequently seen in financing transactions: the Guarantor agrees to pay a debt the Borrower owes to the Lender should the Borrower fail to repay the debt. In a small business context, most Banks require small business owners to guarantee a loan to their business. In the end, the Company gets a loan and the Bank gets added security of the Owner’s personal assets. The Owner, however, risks his or her home and personal property.
Banks usually require a small business owner to guarantee a loan to the business because of basic corporate law. Duly organized and capitalized corporations, limited liability companies and limited partnerships insulate their Owners from the Company’s obligations. An Owner generally cannot be held liable for the debts of a corporate or LLC. As such, a debt of the Company is not a personal obligation of the Company’s Owner. However, through a guarantee, the Bank causes the Owners to risk their own assets and become liable for the Company’s obligations. While this is standard practice for a loan at a traditional bank, there are other options for financing when an Owner balks at providing such a Personal Guarantee.
From a small business perspective, entering into a financing arrangement that requires Personal Guarantees may be the right business decision at one point and not at another point in the lifeline of a Company. Either way, Companies should carefully consider the pros and cons of each type of financing arrangement and negotiate a deal that works best for their current situation.
When a Company obtains a loan from a Bank, the Company executes a Loan Agreement (or a Credit Agreement) and the loan is evidenced by a Promissory Note. Additionally, the Bank usually requires a Personal Guarantee to be executed in favor of the Bank. Under the Personal Guarantee, the Bank can take possession of the personal assets of the owners should the Company default on the loan.
Typical language from a Guarantee provides that “the Guarantor irrevocably, absolutely and unconditionally guarantees to the Lender the full and complete performance of any and all obligations of the Borrower to the Lender.” The obligations of the Guarantor to the Bank are not typically capped at a fixed amount, but rather cover all of the Company’s obligations to the Bank. These obligations will increase over time as the amount of the Company’s loan or lines of credit increase over time.
While the requirement to provide a Personal Guarantee may seem burdensome for an Owner, traditional lenders continue to require them in small business loans. However, not all Owners want to provide a Personal Guarantee. In that case, small businesses are turning to alternative financing arrangements, such as business credit-card loans or factoring in order to avoid the Personal Guarantee requirement. Finally, Companies that have grown sufficiently in size and revenue, or have enough assets in order to qualify for asset-based lending, are typically exempted from Personal Guarantee requirements of a traditional bank.
Another type of guarantee seen in Company financing arrangements is a Validity Guarantee. In factoring– a type of financing where the Company sells its accounts receivables in order to obtain working capital financing– the Lender, who is typically called a Factor– provides cash to the Company in exchange for the right to collect payment on specific receivables. In this relationship, the Factor is not looking to the Company or the Company’s Owners for payment; the payment obligations in factoring is with the account debtor. As a result, the Factor wants certain assurances from the officers or managers of the Company on the financial health of the Company and the account receivables that are being sold.
Validity Guarantees are not promises to repay the Factor, but are promises made by an individual involved in the operation of the Company that the reporting made to the Factor is true and accurate. The individual executing the Validity Guarantee is not liable for the underlying financing, but is liable for losses as a result of fraud or gross negligence in the reports provided to the Factor.
Typical language of a Validity Guarantee may provide that “the Principal [who is the person in charge of the day-to-day operations of the Company] covenants and agrees, for the benefit of the Lender, that the Principal will not (a) provide information material to the obligations that is inaccurate or misleading, (b) conceal any information which is required to be delivered to the Lender, (c) fail to cause any collateral to be turned over to the Lender, or (d) otherwise take any action that constitutes fraud or conversion.” Through this language, the Factor is reassured that the information the Company is providing regarding the receivables is accurate and complete.
Enforcement of Guarantees
While the decision on how to obtain financing for a Company involves more elements than whether a requirement for Personal Guarantee is required or not, the decision to personally guarantee can have serious consequences for owners. If a Personal Guarantee is in place, a small business failure frequently triggers a personal bankruptcy, even if the Owners have taken all other corporate precautions to shield themselves from personal liability for Company debts. Business trade publications are full of stories of failed business and Owners who now find themselves on the hook for millions of dollars of bank financing or lease obligations.
Donald Trump is a good example of this perspective. While his businesses have filed for bankruptcy over and over, he has never filed bankruptcy personally. Following a scare in the early 90s over his liability through some Personal Guarantee on real estate, Trump has steered clear of Personal Guarantees and, so far, has kept out of personal bankruptcy.