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8:00pm EDT September 25, 2009

With banks’ commercial loan portfolios under increased regulatory scrutiny, the personal guarantee is becoming a more important structure point for many financial institutions.

Of course, this is a delicate subject for many business owners, as the personal guarantee can place additional risk on the owner as a source of repayment.

“Ultimately, banks want to partner with clients in a way that positions them on the same side of the desk as the business owners they work with,” says Jim Geuther, manager of commercial banking at FirstMerit Bank. “The personal guarantee effectively strengthens the bank-borrower partnership by providing mutually satisfying financing solutions.”

Smart Business spoke with Geuther about how personal guarantees work and what business owners need to know before making one.

What is the purpose of a personal guarantee?

The purpose of the personal guarantee is twofold: It is a risk mitigant for the bank in terms of the overall structure of the loan package, and it serves to properly align the interest of the bank and the guarantor with regard to the commitment to repay the debt obligation.

At its most basic level, a bank provides capital to a commercial venture when there is a valid economic purpose combined with a highly certain ability to return that capital. In completing its due diligence, the bank will place strong emphasis on its sources of repayment. The primary and most important source is always cash flow, while the secondary repayment source is the value of the collateral. If these two sources of repayment show a bit of weakness, the personal guarantee can be enough of a risk mitigant to allow the bank to provide the loan.

What are the different types of personal guarantees, and how do they differ from one another?

There are variations of personal guarantees: the limited guarantee or the unconditional and continuing guarantee, either of which may be secured or unsecured. As the name suggests, a limited guarantee specifies a dollar amount or percentage of the amount guaranteed.

An unconditional and continuing guarantee applies to all of the debt that the commercial borrower has (or will have in the future) with the bank. A secured guarantee takes this a step further, whereby the bank will ask the guarantor to pledge personal collateral.

Who chooses which type of personal guarantee will be needed?

The type is negotiated between the lender and the borrower. The bank may ask for the guarantee in return for providing additional flexibility on some other points of the structure. For example, clients may prefer longer terms on their deals. They may want a two-year line of credit instead of a one-year line of credit. Or they want financial covenants that give them a little more room. The bank may say, ‘We’ll do those things, but we would like to have a personal guarantee.’ It’s part of the overall negotiation process. Unless you’re in a distressed situation — then the bank may require a guarantee in order to continue providing credit. This is typically caused by a shift in perceived risk. In these situations, banks simply want to return the risk profile to the same point it was at loan inception. Often, this can be accomplished by adding a personal guarantee.

How do banks handle distressed situations?

Of course, there are varying degrees of distress. Regardless of severity level, maintaining a cooperative relationship between the bank and the borrower usually leads to the best possible outcomes. Ultimately, banks want to protect their capital and have their loans repaid. When repayment appears to be in jeopardy, there are businesses that result in a wind-down or workout scenario, which is usually one of the last resorts — this is when the personal guarantee becomes an issue for the provider. Typically, the bank and the business owner will work collectively to exhaust the cash flow and collateral repayment sources before looking to the guarantor to cover any shortfall.

Are personal guarantees necessary for every business?

Absolutely not; again, the strength and predictability of the first two repayment sources (cash flow and collateral value) is the largest determinant here. In general, if there is significant cushion over and above the loan amount in those two areas, the owner will not be asked to provide a guarantee.

However, the willingness of an owner to do so can have a material effect on the flexibility of the bank and type of deal structure that can get done. And most significantly, the personal guarantee demonstrates the highest level of commitment in the bank’s view with regard to a successful two-way relationship.

What type of loan flexibility is available?

Business owners who provide their personal guarantees in effect demonstrate their confidence and commitment to the company, as well as their banking partnership. In exchange for the guarantee, banks may offer longer terms on a loan, more favorable pricing or more flexible financial covenants. It’s part of negotiating the entire loan package.

Not surprisingly, most business owners have the majority of their personal wealth and cash flow tied to their businesses. As a result, many find that providing their personal guarantees is a non-event. There are certainly others who are more reluctant for a variety of reasons. Regardless, it is recommended to speak with your banker to fully understand the benefits and potential risks of providing personal recourse.