Up Close and Personal…Guarantees
One of the main advantages to incorporating a business is to better allocate risk: incorporation helps protect your personal assets (most obvious being your house, car and bank account) from the liabilities and debts of your business. Incorporation makes the business an independent legal entity. Separate and distinct from you – just like any natural person – the company has its own assets and liabilities; it has its own bank account; it enters into contracts; it can sue and be sued. In essence, it is a “stranger” from you personally. Therefore, generally speaking, if the company gets itself into debt, only the company’s assets are potentially on the line – not yours. This allows you, as a business owner, to enjoy a certain amount of freedom to take risks, enter into contracts and carry on business, without the worry of losing your shirt if the venture is not successful or somehow gets into financial trouble.
Sound too good to be true? Technically it isn’t. From a practical perspective though, it just might be. When businesses (especially new businesses) seek out financing, lenders will evaluate the credit application and credit-worthiness of the business. As part of that, in order for the business to be approved for a loan, there is oftentimes a requirement for the loan to be supported by personal guarantees from the owners.
The language around personal guarantees varies tremendously and you should always read very carefully before signing. Essentially though, the effect of a personal guarantee is that it is a commitment from the guarantor (i.e. you) that if the debtor (i.e. your company) doesn’t pay, the guarantor will be responsible for some or all of the debt. In the simplest of terms, it works like this: the bank lends the company money and the company has the primary obligation to repay its debt. If the company fails to, the guarantee kicks in and the bank can collect on the debt from the guarantor. In some cases, a lender has an obligation to exhaust its recourse against the debtor before calling on the guarantee. In other instances, it does not.
A personal guarantee might be a requirement for a variety of credit-related reasons:
- The business may not have much it can use as collateral to support the loan;
- The business may be taking on high-risk projects;
- The business may be brand new and therefore lacking in credit history or credibility.
Or, it may be as simple as the lender requiring the owners to have some “skin in the game”: if a lender is going out on a limb to provide financing to the company, it may want the owners to have a sense of responsibility and obligation with respect to repayment.
In either case, a call on the guarantee means that the personal assets of the guarantor may be at risk. This includes your personal investments, vehicle, bank accounts and even your interest in joint spousal property such as a joint bank account or your matrimonial home.
While there may not always be a practical way to avoid this if you need financing from a lender, there are ways to plan and be ready for it. There are two important things you should do: you need to really understand what you are signing and what the rights of the lender are, and you need to seek out some advice on when and how to structure and organize your personal and family assets so as to properly protect them.
Securing bank financing could very well be the springboard to take your business to the next exciting level. A personal guarantee may be a condition of that financing, but don’t be scared off. Knowledge and experienced guidance can help you work with the lender to take the business successfully forward.
(Featured Article in NLOWE’s The Advisor -Winter Issue)