A longtime friend of mine and I had a conversation recently about how when her father closed down his small business and retired, it was like a death in the family. One of the inherent characteristics of small business owners is that their lives are almost completely intertwined with that of their businesses. An owner is always thinking of his or her business and its effect on his or her family as well as the impact that changes in the business have on the employees of the company and their families.
When business owners incorporate or establish an LLC, they can minimize the personal legal liability from actions arising inside the business; financial matters are different, though. Many times, business owners will have personal assets at stake beyond their investment in the company, often in the form of a personal guarantee of bank debt. Today’s post will focus on personal guarantees.
What is a personal guarantee?
A personal guarantee can be limited or unlimited and it puts an owner on the hook if the business cannot meet its bank obligations. These guarantees are most commonly found on pieces of debt that generally carry less collateral, such as a line of credit.
Why do personal guarantees exist?
A mortgage on the building or debt on a piece of equipment comes with specific collateral, but a line of credit, which is often due on demand, has no such obvious attachment. A line of credit agreement may be written in such a way that substantially all of the assets of the company act as collateral. In other words, if the lender calls the loan, and the business cannot pay it off, it will have to sell components of the business to pay off the debt or attempt to refinance the loan with another lender.
A lender may require personal guarantees for debt if the assets of the company will not be enough to satisfy the amount of the debt. This is common in the early stages of a business, which may need a number of months of working capital in the form of a line of credit but have no substantial assets yet. Service companies that have few tangible assets may be subject to the personal guarantees of owners on debt. Companies that have endured recent struggles may also be required to have their owners personally guarantee the line of credit.
How do you avoid personal guarantees?
Depending on the financial status of the business, an owner may be able to negotiate out of a personal guarantee when the agreement is being created. Typically, though, a lender needs collateral to ensure it can get its money back if something happens to the business. If the only way to finalize a loan is to have a personal guarantee, that’s a decision that the owner has to make. A business owner can potentially avoid the need for a personal guarantee if he or she puts enough capital into the business, although this really acts in the same manner as the guarantee, except under the guarantee, the owner puts up money contingently; in a capital infusion, the money is invested immediately.
How do you get rid of them once they are there?
Different businesses look at personal guarantees differently. Some view them apathetically. They figure that they are so invested in the business, that if it fails, they are going to be in personal financial trouble regardless of a guarantee. Others, perhaps family businesses with an owner close to retirement, view the personal guarantee as a risk.
A lender may be willing to remove a personal guarantee if certain benchmarks or milestones are attained in the business. If a business owner wants the guarantee removed, he or she should have an active conversation with the lender about what it would take to alleviate the guarantee. In the case that a guarantee cannot be completely removed, the owners ought to find out what would need to occur for an unlimited guarantee to be reduced to a limited guarantee (or for the limit of the guarantee to be reduced).
In the long run, success of the business and adequate equity are two good ways to minimize the need for a personal guarantee on business owners. This may require an owner keeping more money in the business early on and enduring a lower rate of return on investment until there is sufficient capital in the business.
By Dan Massey, CPA, Manager