You’d be surprised how many business owners sign a personal guarantee with the bank without fully understanding the risks, which can be as extreme as loss of the business and the family home.
Most people need a bank loan to grow a business, and these days it’s rare for a business owner to be able to secure a bank loan without a personal guarantee. Fortunately, most will never have their guarantee called on, but for those who do suffer this fate the experience can be life changing, testing their financial and emotional reserves.
Understanding the basics of personal guarantees and the differences between the different types will reduce the prospects of a worst case outcome.
Firstly, there are four types of personal guarantees:
1.The standard personal guarantee is an agreement that makes the guarantor liable for the debts of another party.
2. A several guarantee is where there is more than one party to the guarantee but each party is liable only for their respective obligation. For instance, where there are three equal partners who are severally liable for a debt, the bank can recover only one-third of the debt from each guarantor.
3. A joint and several guarantee sounds similar but is quite different. A joint and several guarantee means each guarantor is liable for the full debt, regardless of the percentage of ownership the guarantor has in a business. Although the bank cannot recover more than is owed, it can claim repayment of the entire debt from any of the guarantors. This means that if the bank recovers the full debt from one guarantor, that party can then pursue the other guarantors for their share of the debt.
4. An “all monies” guarantee secures the obligations of the borrower in respect of a specific debt, for example, an overdraft plus all other obligations such as leasing liabilities.
So, why do banks take personal guarantees?
Banks tend to regard personal guarantees as secondary or “make weight” security. That is, the primary security is the business and its assets usually held under a PPS (Personal Properties Securities) Agreement. Banks take additional or backup security in the event their primary source of repayment isn’t sufficient to fully clear the amount owing.
The other reason banks take personal guarantees is the moral factor. Banks work on the premise that business owners will do whatever it takes to meet their obligations rather than face the humiliation of becoming publicly bankrupt.
Many guarantors are under the false impression that a bank can call on a personal guarantee only once all other avenues of recovering a debt, such as selling the business, have been exhausted. This is incorrect! Banks have the right to call on a guarantee as soon as a borrower is in default, although most banks do in fact seek to recover their debt from the assets of the business and then look to the personal guarantors for any shortfall.
Ideally, banks want personal guarantees from parties who hold tangible assets in their own names, especially residential real estate. If the home is in your partner’s name, the bank will likely insist on taking a personal guarantee from your partner. More grief and litigation flows from guarantees given by spouses particularly where that spouse owns the family home.
Trying to sort this out after a guarantee is called can be a nightmare. While banks are obliged to make sure the guarantor knows what they are really signing, the guarantor must also take responsibility for ensuring they fully understand the implications of signing a guarantee.
Guarantees are very hard to retrieve once they have been given, but there’s no harm in asking the bank what you need to do to get your guarantee back. If you don’t ask, you don’t get and if the bank really wants to keep your business it just may be prepared to discuss how it could release or at least reduce its reliance on your guarantee.
Remember, whether or not you actually sign a personal guarantee for the bank or any other supplier, you can still be held personally liable for debts incurred by the company of which you are a director. If you breach your fiduciary duties, personal assets including the family home could be at risk to cover amounts owing to the bank, the tax office, suppliers and employees.
The only way to be sure your guarantee is never called is to not give it in the first place. If you have to sign a personal guarantee, know exactly what obligations and responsibilities you and your co-guarantors are up for and when you are doing your analysis use worst-case rather than best-case assumption.
Three Tips to managing a personal guarantee:
- Be particularly diligent when it comes to having spouses/partners sign personal guarantees especially if they own the family home.
- With joint & several guarantees make sure you are 100% clear as to the financial strength of your co-guarantors. If you are the one with by far the most wealth be extra cautious.
- Accept that the worst case scenario in giving a personal guarantee is that you could become bankrupt. If you can’t handle this possibility don’t give the guarantee in the first place.