The pitfalls of personal guarantees
Personal Guarantees are a serious matter that make you liable for the debts of your business or the debts of other individuals. The use of personal guarantees is increasing across the board. Parents are often guaranteeing mortgages for their children. Company owners are often giving their personal guarantee on business borrowings or leases.
In the case of business, limited liability was designed to separate the affairs of the shareholders and directors from the affairs of the business. Personal guarantees erode this protection, in some cases quite substantially, and that’s not a good thing.
We advise all company directors to avoid personal guarantees whenever possible. However, it is next to impossible to avoid acting as a guarantor when borrowing money. If you use your own mortgage to put funds into the company you’ll be personally responsible for the debt, and could stand to lose your house if you can’t repay it. If you borrow funds by business loan, the bank or finance house will almost certainly demand a personal guarantee.
Another area where personal guarantees are becoming common place is commercial leases.
What is a guarantor?
A guarantor is someone who agrees to repay another person’s debt (or a company’s debt) if that person (or company) defaults. If an individual enters a “personal insolvency procedure” (bankruptcy) or the company is placed in liquidation, the creditors can and do pursue the guarantor to repay the debt.
As a result, company directors who guarantee their company’s debts will be personally liable if the company goes into liquidation. It’s not uncommon for families members to act as guarantors as well.
What does a guarantee cover?
One thing that genuinely surprises many people is that a personal guarantee usually covers both the current loan and any future borrowing.
This means that in addition to covering the existing loan, the guarantor is often covering all the existing debt incurred prior to them signing the guarantee and any future loans that may not have even been contemplated. That might include any refinancing done at a later date or specific debts like credit cards, car loans or an overdraft. This applies both to business borrowing and mortgage finance.
Any other surprises?
Well, yes. The creditor doesn’t have to pursue the borrower first unless the contract expressly states that they must. They can go after whoever has the deepest pockets and that might just be you. Whether or not the borrower is solvent is irrelevant.
- How much risk? Know how much risk you are prepared to accept before contemplating a personal guarantee. Do you really want to bet your house on something? In the case of business borrowing, talk to your accountant about the liquidation value of your company so that you know what is at stake in the event of a business failure.
- Get legal advice. If you are asked for a personal guarantee get legal advice. You may be able to limit your exposure by capping or limiting any dollar figure or by expressly stating the number of years the guarantee is in effect. Structure your personal guarantee to minimise risk.
- Negotiate on the terms. Mention the personal guarantee up front and make it part of the loan negotiation from the outset. Usually the bank will leave this to the end as “standard practice” but it is negotiable. Can you avoid a guarantee in exchange for a higher interest rate? If not, can you be released from the personal guarantee once a certain amount of the principal is repaid? What are the banking covenants associated with the loan? Can the personal guarantee be reduced in exchange for exceeding key financial metrics?
- Bargain on your lease. If you are buying an existing business, try to negotiate a new agreement with the landlord. If you are leasing premises, try pushing back on any request for a personal guarantee. The strength of the landlord will likely depend on how long the premises have been vacant.
- Know how to get out. Ensure that you are in a position to release your guarantee once the current debt is paid off.
- Records. Keep a log of all guarantees from the start of the business. If you trade for a number of years it’s very easy to forget about a piece of paper signed years ago. If the business where to go into liquidation you can get a very nasty and very personal reminder.
- Get regular updates. If you are guaranteeing borrowings you should insist that the bank sends you statements so that you are aware of any defaults. The bank is not required to do this but will do if it’s agreed with the borrower. This has two advantages: it acts as an early warning system of any trouble and will also provide added discipline for the borrower who knows that you have full visibility.
- Follow up your release. Once a debt is repaid, remember to ensure that your guarantee is released immediately. You should be aware that banks and companies don’t do this automatically so make sure you follow up.
Personal guarantees for business
Requests by suppliers for a personal guarantee are increasing. Our advice is to shop around. We’re aware of a number of suppliers who routinely request personal guarantees but will relent if the customer pushes back. If they don’t, others may – don’t hesitate to bargain.
Limited liability was invented to allow entrepreneurs to take calculated risks and we would hate to see this right routinely eroded. There is a lot at stake.
This article is not exhaustive and obviously general in application. We hope that it helps you think seriously about personal guarantees and some tips for dealing with the negotiations. Always get legal advice before signing anything and talk to your accountant about the commercial implications.