Personal Guaranties Explained: What Business Owners Should Know Before Signing
Forming a limited liability entity can help create separation between a business owner’s personal assets and the company’s liabilities and obligations. However, when you are operating and growing your business, you may be asked to “personally guarantee” a loan, lease or vendor agreement. What may seem like a routine box to check may quickly turn into a personal financial crisis if a downturn, dispute or missed payment occurs. Thus, a personal guaranty can be one of the most consequential documents a business owner signs. While entities can also serve as guarantors, this article focuses on the specific scenario of individual personal guaranties.
What is a Personal Guaranty?
A personal promise to pay if the business cannot
A personal guaranty is a legally binding agreement in which an individual assumes personal responsibility for a debt or contractual obligation if the primary obligor (typically that individual’s business) defaults or fails to meet its obligations.
A lender, landlord, or supplier may extend credit to a business on the condition that one or more individuals agree to personally guarantee the payment and performance obligations of the business. In a typical unconditional guaranty scenario, if the business defaults, the creditor can pursue the guarantor’s personal assets to satisfy the business’ obligations.
Why Do Lenders Require Personal Guaranties?
Reducing risk when lending to a business
From a lender’s perspective, lending money to any business involves risk, especially with limited liability entities whose assets are modest or already pledged to other creditors. Personal guaranty agreements mitigate some of this risk by creating additional security for the lender to ensure the loan is repaid if the business defaults.
For many small business owners, a personal guaranty can be the key to secure financing to grow or improve their business. They allow business owners to more easily access credit or obtain better terms than they would based solely on their business’s financial status.
Additionally, a personal guaranty can help align the guarantor’s financial interests with the business’s performance. Since the owner’s personal assets may be at risk, the lender has the additional assurance that the owner is committed to the business’s success, as well as the repayment of the debt.
Types of Personal Guaranties
Unlimited, limited, and conditional guaranties
Personal guaranties are most common in commercial transactions where credit is extended to a small or thinly capitalized business. They frequently appear in commercial loans, SBA and other small-business financing, and equipment or vehicle financing. Landlords also commonly require them in commercial leases, particularly when the tenant has limited assets or credit history. Additionally, vendors may require personal guaranties before providing goods or services. In each of these situations, the guaranty gives the creditor an additional source of repayment and/or performance if the business fails to meet its obligations.
Not all personal guaranties impose the same level of liability for the guarantor. An unlimited personal guaranty can make the guarantor responsible for the entire unpaid obligation, plus interest, collection expenses, and attorneys’ fees. If there are not enough liquid assets available to cover the obligation, the lender may be able to pursue other physical assets such as real estate or vehicles.
A limited personal guaranty restricts the guarantor’s level of exposure to the obligation. Depending on the provisions of the agreement, the limitation might be a maximum dollar amount, a percentage of the debt, a defined period of time, or upon a specific occurrence of events.
Some alternative forms of personal guaranties include “bad-boy” carve-outs and burn-off provisions. A bad-boy carve-out generally imposes personal liability only when the borrower or guarantor engages in certain prohibited conduct. This can include fraud, misrepresentation, misappropriation of funds, or a failure to maintain required insurance, or other acts that increase the risk to the lender. A burn-off provision reduces or eliminates the guarantor’s personal liability after certain conditions are satisfied, such as if the business makes timely payments for a specified number of years or reduces the outstanding principal below an agreed amount.
Important Considerations for Business Owners
Unlimited, limited, and conditional guaranties
Before signing a personal guaranty, a business owner should determine the exact obligations that are included, how much liability the personal guaranty creates, and how long the liability will continue. Some guaranties apply only to a specific loan, lease, or purchase agreement, while others cover all present and future obligations the business owes to the creditor.
Business owners should also determine whether the personal guaranty is continuing, which means it will remain effective in loan renewals, lease extensions, or if the original agreement is otherwise modified. In such cases, the guarantor may remain liable even without the lender obtaining their additional consent. Further, selling an ownership interest does not necessarily eliminate a personal guaranty, and a guarantor may continue to face personal liability unless the creditor provides an express written release.
Finally, a business owner should also review the waiver provisions within the agreement. Personal guaranties may remove standard legal protections for the guarantor, including a waiver of defenses, a waiver of notice of default, or a waiver of the right to require the lender to formally demand payment from the borrower before pursuing the guarantor. Additionally, a business owner should determine exactly what qualifies as a default, since it may be more than just missed payments.
Can Personal Guaranties Be Negotiated?
What to review before signing
Although creditors may present personal guaranties as standard documents, in some cases, they may be negotiable. Depending on the business’s financial strength and other factors, the owner may be able to negotiate a cap on liability, limit the guaranty to a percentage of the debt, add a burn-off provision, or restrict the personal guaranty to a specific transaction.
Conclusion
A personal guaranty has the potential to provide a business with greater access to financing, property, or equipment that would not otherwise be available to them. At the same time, it can blur the lines of separation between a limited liability business’s obligations and an owner’s personal finances. Thus, personal guaranty agreements should be carefully reviewed for their scope, duration, default provisions, and waivers.
Kelly Callahan of Liff, Walsh & Simmons is a Partner in the Banking & Finance Law, Real Estate Law, and Business Counseling, Contracts & Transactions Law practices. Her expertise spans across a diverse range of practice areas including matters involving complex commercial loans and title matters, real estate transactions, commercial leasing, mergers and acquisitions, contract negotiations, and general business counseling.
At Liff, Walsh & Simmons, our attorneys possess the wide array of skills necessary in today’s marketplace to navigate even the most complex business matters. Our clients benefit from our firm’s comprehensive set of service areas and cross disciplinary approach ensuring that our client’s interests are protected at all stages of the business lifecycle. Please contact Liff, Walsh & Simmons at 410-266-9500 to schedule a consultation.
