Taking it personally: what you need to know about personal guarantees
The Covid pandemic has left Main Street businesses in flux all over the country. Now more than eight months in, business owners are focused on understanding their finances to inform efforts to economize operations and take advantage of revenue opportunities. Likewise, lenders and landlords are taking stock of their small business portfolios to assess the value of pursuing collection efforts on past due debts. An essential element to either analysis is the presence, and the power, of personal guarantees.
The basic concept
Personal guarantees are an integral part of small business financial relationships. Required for nearly every federal and state backed small business loan, a personal guaranty is a written promise from a business owner guaranteeing payment of business obligations in the event of a default. It is a statistical truth that lending money to small businesses is a risky, albeit potentially profitable, proposition. As a result, lenders have adapted by offering to advance money, but only if business owners assume a portion of the financial risk as well. In essence, a personal guaranty represents the financial investment a business owner is willing to risk on the future health of a company.
Calling a guaranty
The importance of a personal guaranty comes into focus when a business is no longer meeting its debt payment obligations in a timely manner. In the face of extended periods of default, creditors holding a personal guaranty may seek to collect on a business’ outstanding balance directly from ownership.
In most instances, personal guarantees are unsecured by any physical assets. For these unsecured promises, a lender can attempt to collect by demand, and if necessary, by obtaining a judgment in a court of law. Collecting an unsecured guaranty can be very expensive—creditors considering pursuing such an avenue should carefully review the personal assets of the guarantor to determine the ultimate likelihood of collection. If it is going to cost more to pursue a guarantor than can ever be recovered, the effort makes little economic sense.
In some circumstances, a personal guaranty will be secured by specific assets. A secured guaranty is collateralized by something of value owned by the business owner, which the lender then has the right to assume or sell in satisfaction of the outstanding debt. In most instances, these guarantees are secured by a mortgage in the personal home of the business owner, meaning that the lender has the right to foreclose, sell the home, and apply the proceeds to the balance of the obligation. Just as before, it is important for a lender to assess the economic value of foreclosure before filing suit. Although Maine real estate values have been steadily (and rapidly!) climbing over the past few years, it is likely that a mortgage securing a business guaranty will be, at the very least, second in line to the mortgage securing the loan used to buy the home. In the event of a foreclosure sale, proceeds are paid on obligations in order of seniority until each is fully met, and a lender should project whether or not an auction is likely to produce significant proceeds to be worth the time and effort to pursue.
Working toward a solution
Ultimately, most business owners and guaranty holders find that negotiation is the best way to resolve past due debts, resulting in the maximum return at the lowest cost, and protecting the possibility of business recovery at its most necessary. The best defense ownership has to paying on a personal guaranty is the prospect that the business can repay the debt on its own given enough time.
If you find yourself on either side of negotiation surrounding existing debts, you may benefit from guidance provided by your lawyer. If you need assistance with the process, our attorneys are here to help.