Personal guarantees — When business is personal

October 3, 2018

By Martha Sullivan, CPA, CVA/ABV, CM&AA, CEPA
Partner, Succession Planning Practice Leader

Martha leads HK’s succession and exit planning services division and is a regular contributor to Wisconsin’s InBusiness digital magazine.

    If your business has debt, it is very likely that you, as an owner, were asked to sign a personal guarantee for the debt. Personal guarantees are often required by banks and always required by the Small Business Administration for any of the loans written under their programs. Personal guarantees are an effective tool used by lenders to ensure that they have another route to recover their losses should the business be unable to repay the loan in accordance to the agreement.

    Two weeks ago, at the bimonthly meeting of the Wisconsin Chapter of the Exit Planning Institute, I heard all sorts of bells going off in my head as I listened to David Sisson, John Wink, and Greg Monday from Reinhart Boerner Van Deuren law firm. Their message was this: In a default, courts look to the document language to determine what’s fair according to what was technically agreed to in the agreement. What’s technically correct may not be fair — or at least what you and I would consider fair.

    Consider the following case: Two 50-50 owners take out a loan for the business and ultimately they can’t keep up with it. The bank calls the loan and personal guarantees. One of the owners has resources and the other doesn’t. Mr. Moneybags pays just shy of half of the amount of the original debt. Mr. Hole-in-the-Bucket pays 2 percent of the original amount because that’s all he has. Moneybags sues his partner to recover some portion of his payment from his partner. After all, they are 50-50 partners and he shouldn’t be left holding the bag. The court disagreed. The court viewed “fair” as half of the face amount of the debt to the bank according to the loan documents. The settlement agreement between Moneybags and the bank is independent from what the bank ultimately agreed to with the other party. He signed an agreement, was technically on the hook for the whole amount, and paid only half of the debt amount. From the court’s view, Mr. Moneybags only had to pay his fair share at half of the total amount. Absent any other agreement with Mr. Hole-in-the-Bucket, per the court, that’s the end of the story.

    Holy Buckets! That’s not what most of us would say is “fair.” So, let’s break it down:

    • Both parties signed a personal guarantee for the debt.
    • The guarantee was “joint and several” meaning each party, independent of the other, can be held responsible for the entire amount of the debt.
    • The guarantee was unlimited. Again, each party can be on the hook for the whole amount.
    • The matter involves an agreement between the bank, the company, and the individuals with the personal guarantees. The actual corporate ownership structure does not play a role in the legal interpretation and the courts in this matter.
    • The bank was well within its rights to negotiate and recover what it could. As it was, the bank ate over 30-40 percent of the original amount it loaned to the company. The fact that they only held Mr. Moneybags to half was generous compared to what the letter of the agreement allowed for.

    Considering this scenario and court precedence, what can an individual business owner do to protect him or herself in case things go south?

    First, personal guarantees deserve deep discussions with your banker. Understand the obligation, what may or may not be negotiable, and what actions the bank can take. Go in with your eyes wide open.

    Second, have a parallel agreement in place between the owners outlining what happens if the loan goes into default. Specifically:

    • Consider what the basis for the allocation of liability should be. It’s not as clear-cut as it may appear. For example,
      • Should the allocation simply follow the ownership percentages?
      • Should a passive shareholder be on the hook as much as an active shareholder who may be making management decisions?
      • Should each generation be held as responsible as the other even though they may not be in a position of influence and decision-making? How should this evolve as roles and responsibilities evolve?
      • What happens after an owner exits? Many personal guarantees survive past ownership and into death, becoming an obligation of the estate. (Surprise!)
    • Come to a conceptual consensus and get legal counsel to talk through a skeleton agreement. There are technical aspects to recourse and recovery. Like a tough neighborhood, you don’t want to go into this one alone!
    • Prepare before you go to the bank:
      • Don’t wait until the last minute. There is a lot of momentum as a company zooms to closing a loan. By then, people are anxious to get the deal done and use the borrowed funds. There will be pressure on everyone to “just sign,” which only sets the stage for bad things.
      • Don’t have these conversations in front of your banker. Come to them prepared and with your act together. Remember, you want these folks to have confidence in you as they loan you money.
      • You want your documents to work well together. The bank may have specific language that it wants in one or both agreements. Having a skeleton of the agreement between the owners ahead of time will be helpful in the discussions with the bank.
    • Be patient and vigilant. The bank requirements may influence your decisions as individuals and an owner group. Expect that there could be several meetings, conversations, and drafts to arrive at your final documents. Resist the temptation toward blind optimism and to abandon getting the owner agreement.

    Being in default is hard enough. Being in default and left holding the bag is far worse. Personal guarantees are personal, but they are all business when it comes to the courts. As always, be prepared.

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