Advising Small Business Clients on Personal Guarantee Negotiations
For your small business owner clients, signing a personal guarantee has become standard practice as part of the commercial loan approval process. While this is often the price of doing business, what does a personal guarantee (PG) really mean? What, if anything, can your clients do about them?
A PG gives the bank permission to go after personal assets should the business default on the loan. In addition to letting lenders pursue personal assets, many allow the PG to be called for things like technical default, additional borrowings, a sale of assets, death, or incapacitation. Some even allow the lender to obtain additional collateral on demand if the lender determines the loan to be undersecured.
In the case of a partnership, the most common form is a "joint and several" guarantee. This means the lender doesn't have to pursue the personal assets of each partner equally, but is free to pursue those with the largest, most liquid assets. This puts some of the partners at a greater risk of loss and may require them to pursue claims against the other partners – who are often family or friends.
Contrary to popular belief, the legal benefits of incorporation will not protect business owners from a PG. By signing a PG, guarantors give the lender permission to pierce the corporate veil and gain access to savings accounts, cars, and property – including their family home.
Tips for Negotiating a PG
As a trusted advisor, it's important for you to understand not only what a PG is and does, but how you can help guide your small business clients through the murky waters of PG negotiation.
How much risk can they accept?
They need to know their risk tolerance – both business and personal – before even talking to a bank. This will greatly affect the amount and type of loan they should seek.
First, there's the basic calculation of what would be required should the PG be called. Here's where you as an accountant can add value by helping to evaluate the business's liquidation value, taking into account any existing liens and the priority of repayment in case of bankruptcy.
Once this is done, your clients should consider the amount of personal assets they can risk on the loan, including their equity in the business. What is an acceptable amount to gamble? The answer may be nothing – but whatever the number, it should be figured into the initial loan negotiation. The basic equation should be:
Liquidation value of the business + acceptable personal risk > personal guarantee
Be sure to consider factors beyond personal finance when helping yours client calculate their personal risk figure. If they have a spouse who will lose sleep at night or children about to enter college, the PG could dramatically affect their personal life. These issues should be brought to the forefront with your clients and discussed openly.
Define your terms in advance
Review these important questions with your clients and know the answers before they enter the bank:
- Would they be willing to pay a higher interest rate in exchange for no PG or a limited PG?
- Would they consider borrowing less money?
- Would they be willing to put up a higher compensating balance for the money borrowed, which really translates into a higher interest rate?
- Would they consider a shorter maturity date on the loan, after accounting for the added risk of higher monthly payments?
The importance of maintaining control
Once clients enter the bank, they need to remember to keep calm and stay in control. They can't let emotions get the better of them, keeping in mind that everything is negotiable.
Their first step should be mentioning the PG up front. Most banks will want to first negotiate the terms of the loan and then the terms of the PG. Instead, they should bundle the conversation about the personal guarantee with the discussion of other key loan terms, such as amount, term, interest rate, and covenants.
They should also ask the loan officer why the bank wants a PG. Once they understand their specific concerns, they'll be in a better position to address them directly, rather than through a blanket guarantee. They can also ask how big a business needs to be to avoid a PG at that particular bank. While many banks require PGs as a general policy to make sure that the owner is tied to the business, knowing as much as possible about specific concerns will help your clients better understand their ability to negotiate.
Negotiate the terms of the PG
Limit the guarantee: Banks will always want an unconditional or unlimited guarantee. The business owner should start by requesting that the amount of the PG be limited either by the actual dollar amount or by a percent of the outstanding loan. For example, if the business has a $2 million line of credit, the owner can seek to limit exposure to 20 percent of the outstanding balance. If there are multiple owners, they can also seek to limit the amount of exposure by the percent ownership for each partner.
Suggest terms of relief: A borrower can ask to be relieved of the PG after a certain percent of the loan has been repaid.
Modify the reporting requirements: Lenders typically require guarantors to submit personal financial information at least annually. Generally, the borrower should avoid filling out the standard boilerplate personal financial information for a loan. This is a road map for the bank to find and request personal assets. As an alternative, you can work with your client to draft a personal financial statement with the minimum acceptable disclosure.
Decrease PG with improved business performance: Your client can suggest the PG be reduced as a key financial metric improves, such as their debt-to-equity ratio.
Structure when the PG would go into effect: This could be based on the number of loan payments missed, the amount of working capital of the business, or the net worth of the business falling below a specified amount. Also, your clients should consider requesting business days vs. actual days to give them more time for reporting and the ability to respond to changing circumstances.
Ask that the terms of the PG to change over time: For example, the amount or percent could decrease after five years of spotless payments.
Clients need to know what's important to them: Your clients should evaluate the above strategies in the context of their particular business, the loan, their relationship with the lender, and their options for alternative sources of financing. They should know which modifications will provide the most value and negotiate the loan terms, conditions, and the guarantee agreement as a package.
Set limits on the PG
Avoid "joint and several" language if possible: Ask to limit who will guarantee the obligation. If there are multiple partners, try to avoid a joint and several PG. Push for an indemnification guarantee.
Don't cover more than 100 percent: Suggest that each partner carry a percentage of the guarantee rather than each partner carrying 100 percent – state laws may vary on the ability to do this.
Tell them to ask for carve-outs: Seek to eliminate a primary residence or stock in the business as an asset tied to the PG.
Leave spouses out of it: If at all possible, tell clients not to agree to a requirement of having their spouse as a cosigner on the PG. This provides both of them with some protection, because personal assets under the spouse's name will not be included should the PG be called.
While it will rarely be possible for borrowers to avoid a PG entirely, or to get every one of these limitations, they can often improve the terms somewhat. The health of their business and their credit record as well as the strength of their personal relationship with the lender, can impact the success of negotiations. The lender's portfolio, the lender's experience with your client's type of business and the local market, and other factors can also drive the ultimate decision. Even if clients are able only to wring out modest concessions in the guaranty agreement, negotiating it at the same time as the loan can lead to improvements in the loan terms and conditions as well.
Personal guarantee insurance
Another option has become available recently is the ability to insure a PG. This option may influence your clients' decisions as they balance improvements in the loan terms with modifications to the guarantee agreement. Personal guarantee insurance (PGI) can protect your clients and their personal assets. Armed with this coverage, they can limit their personal risk to a more palatable level. If, after taking into account the value of the liquidated business assets, the insured uses personal assets to satisfy the remaining obligation, PGI will cover up to 70 percent of the insured's payments under the personal guarantee, depending on the coverage purchased and the terms of the policy.
The first negotiation shouldn't be the last
As your clients' personal and business conditions continue to evolve, they can approach their lenders to reopen the discussion on terms and conditions of their loan and guarantee. Changes in their financial performance or increases in collateral can lead to more favorable terms, even if they were unable to secure them on the front end.
It may be impossible for business owners to completely escape the snare of a PG. However, your business owner clients do have options. As they rely on your sound advice and adhere to a carefully planned approach, they can confidently negotiate the terms of their PG and loan together. In cases where negotiation isn't enough, the risk mitigation afforded by guarantee insurance can help them focus on the business at hand.
Mr. James R. Coughlin serves as the Chief Underwriting Officer of Asterisk Financial, Inc. In Mr. Coughlin's role of establishing and overseeing the underwriting function at Asterisk, Mr. Coughlin draws upon twenty years of commercial banking experience, including extensive experience in credit risk assessment, risk management and regulatory...