While they are nothing new, personal guarantees (PGs) have become commonplace as tight credit conditions have forced banks to become increasingly conservative in their lending practices.
Most small business experts say it is almost impossible, given the current economic climate, for business owners or partners to completely avoid a PG.
However, the downside to this is that PGs put personal property and cash at great risk.
This happens because a personal guarantee (PG) is a note signed by a loan guarantor – business owner, partner, investor or family member – that pledges personal assets as collateral in addition to the business assets. In the event of a loan default, this signed note gives the lender the right to pursue personal assets like homes, bank accounts and valuables ― sometimes even before the business assets have been liquidated.
However, when negotiating a PG, small business leaders do have options. Armed with good advisors and a carefully planned approach, they can negotiate the terms of their PG and loan together.
Beyond that, personal guarantee insurance from companies such as Asterisk Financial can provide much needed risk reduction and peace of mind.
Because the stakes are so high, it’s critical that a small business leader is armed with a strategy for negotiating a PG with the lender that mitigates some of their most onerous provisions.
“While signing a PG is the norm for most small and medium size business owners, the implications of signing one should be carefully considered. You may be able to negotiate certain aspects of the guarantee, such as limiting or restricting it. One example is carving out a significant asset, such as your home,” James R. Coughlin, Chief Underwriting Officer for Asterisk Financial Inc
Here are some practical steps from Coughlin to take when asked to sign a personal guarantee:
- Know what you are signing – The terms of a PG can vary widely. In many instances, the terms of the PG can permit the pursuit of personal assets in other circumstances besides outright default, including: a technical default, additional borrowings, sale of assets, death or incapacitation. Some PGs even allow the pursuit of additional collateral on demand if the lender deems itself to be under-secured. Another misconception about PGs is that incorporation affords legal protection against a lender pursuing personal assets. In fact, signing the PG pierces the “corporate veil” and allows personal assets to be seized.
- Know who you are signing with – When there are multiple partners involved, they often sign a “joint and several” PG agreement. While the logical conclusion is that this spreads risk out among the partners, in fact the lender is free to pursue whichever partners it wants – which generally means going after the ones with the most liquid assets first. This can lead to the difficult situation of having one partner pursuing relief from the other partners on his own, who are often friends or relatives.
- Know what level of risk you can accept – Before approaching the bank, you as the owner need to determine your own threshold of acceptable risk, both on a business and personal level. To do this you should calculate the assets necessary to satisfy the PG should it be called (keeping in mind that if the business is challenged it and its assets will be worth much less than book value) and then determine how much of your personal assets you can risk on the loan.
- Negotiate the terms of the guarantee – While nearly every term in the PG can be negotiated, it is important to determine the points most critical to you as well as those the lender is most sensitive to changing. This will help to guide your strategy as you negotiate the PG and the loan documents.
- Possible negotiating avenues to consider include;
Limit the guarantee: While banks will always want an unconditional or unlimited guarantee, ask that the amount be limited either by the actual dollar amount or by a percent of the outstanding loan.
If there are multiple owners, you could also seek to limit the amount of exposure by the percent ownership for each partner.
Suggest terms of relief: Ask to be relieved of the PG after a certain percent of the loan has been repaid.
- Don’t let the first negotiation be the last – As your personal and business conditions continue to evolve, do not forget to approach your lender to discuss the terms and conditions of your loan and your guarantee as circumstances may have changed (improved financial performance, increased collateral, etc.). If you have purchased personal guarantee insurance, you may be able to gain some loan concessions.
Here is a special report on how to negotiate a personal guarantee from Asterisk Financial.