Let It Ride

One of the most frequently asked questions by business owners regarding lending and business finance is, “Why does the bank need my personal guarantee?” The answer is fairly simple—they do not!

As a borrower, the business owner has a choice. However, with some financial institutions, the philosophy is best expressed as “my way or the highway” unless the banker feels comfortable with the business operations and the other types of security proposed. Although, if the business and its owner are on sound financial footing there may be room for negotiation regarding personal guarantees. Successful negotiation does not require the Wisdom of Solomon, but it does require an understanding of the processes the parties’ position. Simply put, the business owner wants a loan without having to use personal assets as collateral; on the other hand, banks are risk adverse and want to insure as many sources of repayment as possible. In essence, the bank is torn between establishing a working relationship with the business owner (banks want deposits) and insuring the repayment of loans, thus the phrase, “Who has Whom?” has become popular in commercial banking in relation to the necessity of personal guarantees.

Business owners should understand that the position of a banker in the loan negotiation process is controlled, to a large extent, by the philosophies of the particular banking institution. In general, bankers want to know the business owner is serious regarding the success of the company and is committed to doing everything possible to ensure success. The best way for a bank to test the owner’s commitment to success is to view how willing the owner is to sign a personal guarantee. Remember, banks are in a relationship business, meaning they are primarily concerned with accepting deposits and providing other services involving lending. If a situation goes poorly following a bank’s loan, then it is in the best interest of both the bank and the company to develop a plan to remedy the situation. Banks are generally leery about foreclosing on personal assets unless there has been a lack of cooperation on the part of the business owner. Therefore, does this mean that a personal guarantee really does not matter? The answer is a resounding no and to think otherwise would be, as Horace the ancient Roman poet put it, “as crazy as hauling timber into the woods.”

Playing the game

The “personal guarantee” game, which banks are accustomed to playing during the loan negotiation process, dictates that banks see the cash flow of the business as the primary source of repayment and view collateral (including personal guarantees) as a secondary source of repayment. Of course, this does not mean that a business solely containing solid cash flow will be successful in obtaining a loan – quite the contrary. The complexity of the lending process is due, in many ways, to the fact that banks are highly regulated. As part of this regulatory activity, banks are analyzed for profitability, credit quality, management and other factors. Additionally, banks are subject to a Legal Reserve Requirement in order to assure liquidity for demand deposit accounts.

Historically, some banks have experienced financial difficulty when they have rapidly increased the amount of loans which are carried on their books. This is due to the fact that when the wave of rapid loan activity is over, many of the marginal loans turn into problem credit situations. To lessen this burden, regulations require banks to rate and monitor each loan using various risk ratings. William F. Treacy, of the Federal Reserve Board, describes risk ratings as “…internal credit ratings which are becoming increasingly important in credit management at U.S. banks. Bank’s internal ratings are somewhat like ratings produced by Moody’s, Standard & Poor’s and other public rating agencies in that they summarize the risk of loss due to failure by a given borrower to pay as promised.” By understanding the lender’s means used to monitor each loan, it becomes more apparent why a personal guarantee would be required. From the lender’s perspective, a personal guarantee indicates a business owner is serious about the company and the repayment of a loan.

Knowing your strategy

There are steps that can be taken to lessen the impact of personal guarantees if they must be utilized by small and medium-size business owners. Remember, signing a personal guarantee does carry with it the risk of having to repay a business loan or subjecting personal assets to liquidation to repay the loan. Conversely, the use of personal guarantees might allow the business the opportunity to secure a loan that it may not have gained otherwise. If a personal guarantee is required, the secret is to negotiate effectively and limit personal exposure.

When a business owner is faced with the decision to sign a personal guarantee, some tips to consider might include:

• Attempt to negotiate limits on the amount of the the guarantee.
• Attempt to negotiate a reduction in the amount of the the guarantee as certain business milestones are met.
• Attempt to negotiate limits on the use of the the guarantee unless gross negligence, or even even worse – fraud, is committed in managing the business.
• Attempt to avoid “blanket guarantees” by negotiating with the lender and and state that remedies against the collateral supporting the loan will be utilized first.

Implementing the concepts

If the use of a personal guarantee cannot be avoided, a business owner may seek to limit the amount of the guarantee. The following example illustrates this principle:

The owner of “Small Co.” wants a $200,000 working capital line. There are sufficient business assets to fully collateralize the loan. The business owner may seek to limit the exposure on the personal guarantee to 10% or $20,000. In this example, the lender receives the sufficient collateral needed while, at the same time, gaining sufficient psychological commitment from the business owner. The business owner gets what he or she needs in that all of the personal assets are not subject to repayment. This type of limitation is also appropriate when multiple owners exist. Multiple business owners should seek to limit their exposure on personal guarantees to correspond with their percentage of ownership.

What the ‘house’ faces

When analyzing credit in the loan decision process, banks examine various financial ratios. Cash flow is vital among these ratios and, in particular, operational cash flow to current portion of long-term debt. This ratio measures the ability of a business to make principal payments and the availability of additional borrowing capacity. Basically, the higher the operational cash flow in relation to the current portion of the long-term debt, the less risk posed to the bank in terms of loan repayment.

Perhaps a business owner faced with a personal guarantee requirement should consider negotiating with the bank to have the personal guarantee’s amount reduced as the operational cash flows increase. This strategy can also be helpful for the business owner who has previously signed a personal guarantee and now wants to limit personal exposure. The same logic would apply if the bank is focusing on other types of ratios. As with all facets of the lending process, success lies in understanding the bank’s credit decision process and structuring the loan negotiations around this process.

The necessity of personal guarantees, as stated previously, is driven based upon the objectives of the bank. Since banks generate money for the economy by loaning money, their presence is critical to the U.S. economy. Practically speaking, a bank can loan its deposits as high as the legal reserve requirement’s limit.

Consider the following—by understanding the reserve requirement, it may be possible to negotiate limits on the use of a personal guarantee to those instances where gross negligence is committed in managing the business. Unfortunately, most successful entrepreneurs are technically savvy regarding these aspects of the business, and possess an intuitive ability to overcome many obstacles, but lack the formal education to understand how to properly manage the business.

I was once told that the average entrepreneur in America starts out their business in a shoebox. They start their business because their perception is that they are better at what they are doing – say electrical contracting – than was their former boss. That doesn’t make them a businessperson though. That makes them an electrician. The reality is that it takes them a very lengthy period of time to actually create business. In instances where the business owner has had insufficient time to “actually create business,” the bank’s risk increases. This is not because the business owner is a bad person; instead, the business owner does not possess the necessary acumen to properly manage the company. In such instances, attempting to limit the use of a personal guarantee in matters regarding gross negligence would fall in line with the thinking of Johann Wolfgang Van Goethe when he said, “It seems to never occur to fools that merit and good fortune are closely united.”

Keeping your chips in the rack

One final suggestion a business owner may wish to consider when dealing with a personal guarantee is to attempt to avoid a “blanket guarantee.” In blanket guarantees, all of the collateral, both business and personal, may be utilized to satisfy the obligation to the bank. In such situations, the personal collateral may be more attractive from a liquidation standpoint than the collateral from the business. For example, assume the business owner has investments (not including the business) of $500,000 and has been successfully negotiating a credit line for working capital of $400,000; this line of credit is secured by the assets of the business and the owner’s personal guarantee. Further, assume the business is a manufacturing company with specialty equipment and the value of this equipment is driven from the fact that it is in place and operating. The liquidation of that equipment would take an extraordinary amount of time and is virtually impossible.

When the marker can’t be avoided

In the event of default with a blanket guarantee in place, the bank’s most probable action would be to go after the “low hanging fruit” and proceed toward the investments. If however, the owner was successful in negotiations regarding the personal guarantee, the bank would first need to proceed toward the equipment and its liquidation to satisfy the obligation to the bank.

Finally, business owners having signed or facing the decision to sign a personal guarantee should realize that by focusing on the success of the business as opposed to the burdens of the personal guarantee, the concerns regarding a personal guarantee become a moot point. Although, there are situations where one or more of owners is fully capable of successfully managing the business, and is then saddled with the burden of providing a personal guarantee to stand behind a loan. Soon, it becomes evident to these owners that their assets are on the line whereas the personal assets of some of the minority owners are not. The owners supplying the personal guarantee soon become concerned after receiving no special dispensation for supplying the personal guarantee. Additionally, there are situations in which the owner simply has not had sufficient time in operating the company to fully understand the true nature of business. In either scenario the business owner should not fear a personal guarantee, but should use one or more of the tips provided to limit its use. After all – personal guarantees are not necessarily personal.