Secure payments with a personal guarantee

A personal guarantee, a legal commitment where an individual pledges to cover the business’s debts if the promise to pay an obligation is broken, has become a significant tool in the credit industry.

Why it matters: Although a powerful tool, personal guarantees can sometimes fail to meet expectations. By understanding personal guarantees, you can minimize credit risk and increase the likelihood of payment from customers.

Typically, a personal guarantee is required for Small Business Administration (SBA) loans and many online and traditional loans. Even if a business is creditworthy, a creditor may want the extra assurance that the individual owners or executive leadership related to the transaction are willing to fulfill the financial obligation should the company be unable to do so.

If a business fails to keep up with loan payments and the creditor starts to enforce the personal guarantee clause, it could trigger financial repercussions and potentially lead to a court case. If the business can’t cover expenses, the creditor can initiate legal action to seize personal assets for debt repayment.

In B2B credit management, personal guarantees are used to strengthen a transaction for new customers or those without financial strength. “They’ve helped us collect payments if a customer is not paying or responding,” said Bell Silva, credit manager at Marek Brothers Systems LLC (Houston, TX). “After all, people don’t want creditors going after them outside of their company.”

Obtaining personal guarantees

A common way to obtain a personal guarantee (PG) is by including it on the credit application. Typically, this is a separate paragraph at the end of the credit application with the guarantee language and an additional signature block for the guarantor to sign. In accordance with the Fair Credit Reporting Act (FCRA), the language in the application would require consent from the individual guarantor (a consumer) before that consumer’s credit report can be pulled.

Another way to obtain a personal guarantee is to use a stand-alone guarantee, which is a separate document from the credit application.

“It’s easier to obtain a personal guarantee within a credit application because it is on a document that is already being signed—the credit application—and people are more amenable to signing the guarantee when it is included on the credit application,” said Jason Torf, Esq., partner at Tucker Ellis LLP (Chicago, IL). “Whereas with a stand-alone guarantee, you have to put a separate document in front of your customer, ask them to sign it and possibly negotiate terms. A guarantee that is included on a credit application is not nearly as robust and friendly to the party receiving the guarantee because you cannot include significant helpful terms, rights and remedies in a single paragraph on a credit application as you can on a stand-alone guarantee that has room for more robust and seller-friendly terms.”

Another drawback of including the personal guarantee on the same form as the credit application is that you run the risk of losing it should they choose not to sign it again when completing an updated application.

“Even though there is no formal notice rescinding the PG you currently hold, and it is a standalone, separately signed section of the form, some judges would consider the unsigned PG connected with the new application as overriding the one included on the original application form,” said Juanita May, CBF, credit manager at Professional Flooring Supply (Fort Worth, TX). “With this in mind, we have to consider which is more important in each case: an updated application or maintaining the PG we hold.”

Yes, but: The nuances of securing a personal guarantee can be challenging,especially with publicly traded companies where ensuring the enforceability of the guarantee is critically important. In such cases, it is best to have the parent company serve as the guarantor. However, to make it enforceable, the guarantee must provide mutual benefits for both parties. “If you’re providing goods or services to that parent company’s subsidiary, those goods or services increase the value of the parent company’s ownership interest in the subsidiary, which makes the guarantee enforceable,” Torf said.

Enforcing personal guarantees is easier with closely held companies where the primary shareholder, who is also the CEO or president, acts as the guarantor. This creates a leverage situation. “If your customer experiences financial distress and becomes unable to pay all vendors in full, having a personal guarantee from the individual who is also the key decision-maker at the customer significantly increases your chances of getting paid,” Torf said.

To avoid paying out of pocket on the personal guarantee, the principal is more likely to ensure that you get paid ahead of other vendors. “The same leverage concept applies if the customer files bankruptcy, your opportunity to be paid as a critical vendor and to have your prepetition claim paid in full, or at least significantly, is greatly enhanced when or if you hold a personal guarantee from the key decision-maker,” said Torf.

Who’s eligible for a personal guarantee?

One common mistake that credit professionals make is not evaluating the guarantor’s creditworthiness when obtaining a personal guarantee. “The guarantor might have minimal assets in his or her name (assets might be in another person’s name, such as a spouse or a relative, which makes it difficult to collect from them), significant other debt, other liens and judgments that would need to be satisfied before your guarantee claim can be satisfied or simply might not be creditworthy,” Torf said.

Do as you would with any new customer when obtaining a personal guarantee—evaluate the creditworthiness and the collectability of the guarantor. “Too often, companies take a guarantee assuming they are protected, when in reality, the guarantee isn’t worth the paper it is written on because the guarantor is not creditworthy,” said Torf. “In a deal where you determined that a credit enhancement was needed to give terms to your customer, make sure that the credit enhancement you obtain actually has value.”

Here are some helpful tips to evaluate the guarantor’s creditworthiness:

Conduct thorough research on the guarantor. “To evaluate the creditworthiness of a guarantor, we ask them for two or three years of personal tax returns and a current financial statement,” said Michelle Kelly, CCE, CCRA, CICP, senior credit manager at Mansfield Oil Company of Gainesville, Inc. (Gainesville, GA). “We also rely on Experian and Equifax credit reports to compare to the debt reported on the personal financial statement.”

Use all available tools such as online searches, guarantor-provided data and run credit reports on potential guarantors. If the guarantor provided is not creditworthy, you may need to substitute a different guarantor. “I use Google to learn more about them and make sure there’s no kind of bad news such as history of litigation,” Silva said. “I look for the address or region. I look and see if two people are in the company or if anything else is tied to that person.”

Ask questions. Asking the appropriate questions can help you evaluate the guarantor’s creditworthiness and ensure timely payment. These questions include:

• Who are they and how are they related to the entity they are guaranteeing?
• Do they have legal consideration?
• How long has the legal entity been in business?
• What industry do they support?
• Have you verified they are not fraudulent?
• How are they paying their current creditors?
• Who are their customers?

Be transparent. A personal guarantee may lead customers to perceive a sense of threat or take offense, as it potentially places them in a position of unsecured debt. “Many owners do not wish to sign a guarantee as it can limit their ability to obtain personal loans for example,” Kelly said. “Have a transparent conversation with the customer about your risk assessment process. Learn more about their principles and operations and share your concerns. Help them understand the need and the importance of establishing a long-term partnership.”

Collect vital contact information. “Not only should you get the guarantor signature(s), but you should collect the personal contact information for the parties signing,” May said.

Work with sales. Working closely with your sales force makes approaching difficult or uncreditworthy customers easier. Sales can provide information on the customer that you can use in your credit investigation. Working together can also help you find common ground when discussing credit limits with your customer.

The bottom line: Personal guaranties are a significant tool in credit management, providing an extra assurance of debt repayment, especially for start-ups, companies with poor credit, or businesses under five years old; however, securing and enforcing these guaranties can be challenging, and it’s key to evaluate the creditworthiness and collectability of the guarantor to ensure the guarantee’s value.