Steve Jobs once said, “Details matter, it’s worth waiting to get it right.”
This is especially true if the corporation, limited liability company or other organized business entity in which you have an ownership interest is borrowing funds. Whether your business is borrowing from a financing seller, bank or a credit union, you should be prepared for the request that you, individually, guaranty your business’s obligations to the party offering credit.
So what is a guaranty? A guaranty is a written promise given by a guarantor (an individual stockholder or member of the borrower organization, or even by an entity related to the borrower who may be benefitted by the borrowing). This promise says that the guarantor will pay the borrower’s debt to the lender if the borrower fails to do so.
Current market terms for guarantees typically do not require the lender to exhaust any or all avenues of payment from the borrower before looking to the guarantor for payment. Known as “guarantees of payment”, these commitments often include terms allowing the lender to immediately pursue the guarantor for payment in the event of the borrower’s failure to pay. If there are multiple guarantors, current guarantees also typically permit the lender to pursue any one or more of them. For example, if the lender perceives a single guarantor to have especially deep pockets, the lender may collect from that individual. That guarantor, in turn, may pursue contribution from any other guarantors.
Guarantees are useful not simply to obtain additional security for the loan, they also enable the lender to assess a borrower’s potential credit risk. That is, if a borrower’s member or shareholder resists providing a guaranty, the lender may be wary of extending credit. The premise being that if the business owner is hesitant to put his or her individual skin in the game, why should the lender carry the risk? Faced with the likely possibility that you will, as a business owner, be required to personally guaranty your business’s debt, you may still be able to negotiate limits to that guaranty. The guaranty agreement first presented to you very likely will be an unlimited guaranty of all indebtedness your business has to the lender, potentially secured by your personal assets. You may wish to consider and present to your lender one or a combination of limits to your guaranty, including:
- Pro-rated guarantees among the various business owners, based for example on your stock/membership interest. In this way, smaller share owners will bear only the risk commensurate with their ownership interest versus the possibility of paying 100% of the borrower’s debt.
- Request that the guaranty be unsecured. The lender can still sue the guarantor, but will not have an immediately foreclosable security interest in the guarantor’s personal property or real estate.
- Limit the debt covered by the guaranty to a specific loan versus all debt of the borrower to the lender. In this way, the guarantor knows “the world” of the potential obligation versus potentially leaving wide open the debt for which the guarantor could be liable.
- If the lender insists that the guaranty also be covered by security—your pledge of personal property or real estate collateral—seek limits on how much of your property is included. For example, an agreement may be reached whereby you pledge a specific account or parcel of property, rather than a blanket pledge of all of your personal property and real estate holdings.
- Limit the time for which the guaranty is effective. These time limits can be as simple as agreeing to a fixed length of time after which the guaranty expires, or an agreement that the amount guaranteed drops, or goes away entirely, upon the borrower reaching certain financial goals.
The above is by no means an exhaustive list of possible limitations, and as with any agreement, any limits must be in writing or they likely will not be enforceable. If your business is borrowing funds, a guaranty may be unavoidable, but the terms certainly may be negotiable. Experienced Kreis Enderle business and lending attorneys are available to provide guidance.