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.
“If there is no guarantor and it’s a wind-down situation in which the company just won’t survive, sometimes the owner just throws the keys at the bank and says, ‘Have at it. We’re done,’” says Doug Houser, CPA, senior vice president with FirstMerit Bank. “They have no vested interest. But if they have a guarantee in place, they are going to be motivated just as the bank is to get the debt repaid as quickly and efficiently as possible.”
Smart Business spoke with Houser 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 to the bank.
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 several variations of personal guarantees: the limited guarantee or the unconditional and continuing guarantee, either of which may be secured or unsecured. A limited guarantee is specific about a dollar amount or individual loan. 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 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 a longer term on their deal. 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 need a guarantee, otherwise you will end up in a wind-down or a workout scenario.
How do banks handle distressed situations?
Ultimately, it is when the wind-down or workout scenario occurs that 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. When this is the case, a cooperative relationship between the bank and the guarantor will lead to the best possible outcome for both parties.
Are personal guarantees necessary for every business?
Of course, it is not necessary that every business owner provides a personal guarantee to the bank in order to get the desired financing in place. Again, the strength 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, that 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?
If someone stands behind their business and is willing to guarantee it, you may give them a longer term on a loan. They may get better pricing. They may get more flexible financial covenants. It’s part of negotiating through the deal.
If the owner stands behind the business and has all of their personal worth tied up in it, it is usually no problem for them to provide the guarantee. In exchange, the bank may feel that since the individual is strongly committed, it may provide additional flexibility on some other structure points (i.e., longer term, more flexible covenants, better pricing). Again, the type and quality of the guarantee will also affect these points. Smart clients already know this and will use it to their advantage.