Guarantee Alternatives to Improve Your Close Rate

If you are providing financing or bonding to small and mid-sized businesses, your firm will likely require personal guarantees from the principals of the client company. For several years prior to the recent recession, credit was easy and it was possible to get deals done without having personal signatures or pledges to back-stop the risk of default ' not today. With rare exception for those businesses with extraordinary financial strength, obtaining credit of almost any type for emerging growth or middle-market businesses, i.e., those from startup through $100 million in sales, will require guarantees by the owners with 20% or more of the equity in a company. At the same time, financing companies are seeing more competitive pressure and a drive to get transactions closed when they find a good client. This logic applies to lease companies, commercial lenders, asset-based lenders, bonding firms and the like.

Developing an Effective Strategy

A competitive strategy to soften the perceived impact to those making the guarantees and to allow your company to mitigate its risk may be one of the keys to winning new business. Developing an effective strategy for structuring and managing the personal guarantee begins with understanding your firm's objectives and perspective. Start by assessing why your firm really needs the guarantee (other than policy dictates). Is it to assure that you lock-in the significant owner of the client company, so he is tied to the business to increase your likelihood of being repaid (especially if things do not go as planned). Or is it a financially weak business, and you are seeking additional collateral or assets; maybe both ' or to eliminate a conflict of interest between multiple businesses with the same owner. There are a number of reasons. The key is to be clear about why.

Next, put yourself in the shoes of the business owner. Determine the maximum out-of-pocket amount that the guarantor will actually pay if everything goes wrong and he must personally write a check to your firm. Knowing this amount may play into the terms and the amount that he might guarantee. Some owners do not mind guaranteeing their company's debt and risks as long as they are never really at risk of loss ' in other words, their worst case out-of-pocket amount is zero. This may sound obvious, but not always intuitive. Simply by showing the numbers or highlighting the real downside risk to the guarantor (vs. the perceived risk), you may bring value and clarity to the transaction that others won't.

One strategy for individual guarantors is to assure that the amount of debt guaranteed never exceeds the liquidation value of the assets of their business, taking into account the priority of liens and repayment if the business went bankrupt. If they are OK with taking some financial risk in addition to the amount that can be covered through liquidation of the business, then calculate the same liquidation value and add the acceptable amount. Once you have helped the guarantor establish a limit, suggest that he have his controller, bookkeeper or accountant provide a monthly or quarterly estimate of liquidation value based on their actual financial statements. This will provide him and you visibility so he can track and manage the risk being taken.

If you are in a position to shape the deal, use the information above when negotiating the terms of the guarantee so they fit the situation and limits. You are helping the client manage his risk and differentiating your deal from others. Below are some of the deal points that you should consider.

1) Guarantee of Payment vs. Guarantee of Collection ' the most common guarantee is that of payment. This typically means that if the client company does not meet the agreed payments, the lender, lessor or bonding company can demand payment directly from the guarantor without pursuing further action against the company. A fallback position to soften the impact for the guarantor is to offer a guarantee of collection. This arrangement typically requires the lender first exhaust its options against the company before it can demand payment from the guarantor. So if the guarantor never borrows more than the liquidation amount of his company's assets and he made a guarantee of collection, he could avoid ever having to write a check from his personal assets. Alternatively, you may negotiate a guarantee that only provides protection in the event of fraud or wrongdoing; this is sometimes referred to as a fiduciary guarantee.

This type of concession makes sense when you have a reasonably strong client company ' but the collateral is specialized enough that having the principle(s) of the firm engaged in an unwinding (worse case) may make the difference in keeping your deal whole.

2) Limit Scope and Collateral ' Another strategy to focus the guarantee and provide comfort to the guarantor is to limit the scope of the commitment, excluding recourse against his house or other specific property. There are specific laws around the topic of a homestead exemption that the guarantor may see as a compromise by your firm ' that in reality may really be clarification of a right that he already has. Making it explicit in the guarantee documents may provide additional comfort for the guarantor (and his spouse). It may be easier or more palatable to obtain a pledge or lien against specific property, or a pledge of the stock in the business, than to obtain a blanket guarantee.

3) No Spouse Signature ' A hot button for many business owners is having to obtain a spouse's signature for a guarantee. It forces owners to have conversations that they would just rather avoid. From your perspective as the lender, this can be problematic depending upon your objectives and the laws of the state of legal venue. Tread carefully. Obtain financial statements showing only his individually owned assets and liabilities to determine the reasonableness of a single signature. In many cases, the decision of having both signatures goes back to the fundamental reason for obtaining the guarantee in the first place.

4) Set Limits ' quantify the limits on the amount of the guarantee either in relative terms or absolute terms. For example: The client company may have a line of credit with $2 million total availability. Set limits to allow the guarantor to manage the risk to a percent of the outstanding balance or an absolute maximum; maybe 20% or up to $200,000. This is particularly appropriate with multiple owners whereby each desires to limit his exposure based on percentage ownership. Additionally, you may negotiate to reduce the guarantee as the performance of the company improves. As an example: The company has a debt-to-equity ratio of 3:1 post-financing; negotiate to reduce or limit the guarantee when the company's debt-to-equity ratio falls below 2:1. Also consider having the guarantee become less onerous over time, based on a continued relationship with your financing company. For example, a guarantee of payment could convert to a guarantee of collection after a couple of years of a spotless repayment record, or the guarantee could burn off gradually.

5) Adequate Insurance ' Advise the guarantor to obtain insurance covering the collateral for the loan or lease based on limits commensurate with the cost to replace the supporting property. Neither your firm nor the guarantor want to be caught off-guard in the event of theft or hazard ' resulting in the guarantor being obligated to personally pay for lost inventory or property that is part of the deal. Also, encourage the guarantor to purchase business interruption insurance (business income and extra expense coverages) with limits that are in sync with the amount of time and additional expense it would take to restore normal operations after a disaster. In addition, consider fraud insurance to protect against an officer or employee stealing from the company and incurring debt on a line of credit. Broad form property insurance usually covers only a small amount unless specifically added to the policy; increase this policy limit to match the credit facility limit.

Historically and from a practical perspective, guarantees have been form documents that were difficult to negotiate or to get much movement by the lender. Finding ways to compromise or provide additional value as a lender may be just the trick to win new clients that have financing alternatives.

Independent Advice

Lastly, encourage clients to get solid independent advice from experienced legal counsel and financial experts. Taking an honest-broker approach to establishing a long-term relationship with clients is good for your business and theirs; it is easier to do business when everyone is informed. If a client has partners or other shareholders, they may need separate counsel representing them vs. their company. The nuances of the guarantee are specific to each guarantor and their circumstances ' have them get qualified legal advice to assure the terms and concepts fit their situation and work for you as the lender or lessor.

Kenneth H. Marks is the founder and a managing partner of High Rock Partners, providing growth-transition leadership, advisory and investment services. He is the lead author of the Handbook of Financing Growth published by John Wiley & Sons. Marks may be reached at [email protected].

If you are providing financing or bonding to small and mid-sized businesses, your firm will likely require personal guarantees from the principals of the client company. For several years prior to the recent recession, credit was easy and it was possible to get deals done without having personal signatures or pledges to back-stop the risk of default ' not today. With rare exception for those businesses with extraordinary financial strength, obtaining credit of almost any type for emerging growth or middle-market businesses, i.e., those from startup through $100 million in sales, will require guarantees by the owners with 20% or more of the equity in a company. At the same time, financing companies are seeing more competitive pressure and a drive to get transactions closed when they find a good client. This logic applies to lease companies, commercial lenders, asset-based lenders, bonding firms and the like.

Developing an Effective Strategy

A competitive strategy to soften the perceived impact to those making the guarantees and to allow your company to mitigate its risk may be one of the keys to winning new business. Developing an effective strategy for structuring and managing the personal guarantee begins with understanding your firm's objectives and perspective. Start by assessing why your firm really needs the guarantee (other than policy dictates). Is it to assure that you lock-in the significant owner of the client company, so he is tied to the business to increase your likelihood of being repaid (especially if things do not go as planned). Or is it a financially weak business, and you are seeking additional collateral or assets; maybe both ' or to eliminate a conflict of interest between multiple businesses with the same owner. There are a number of reasons. The key is to be clear about why.

Next, put yourself in the shoes of the business owner. Determine the maximum out-of-pocket amount that the guarantor will actually pay if everything goes wrong and he must personally write a check to your firm. Knowing this amount may play into the terms and the amount that he might guarantee. Some owners do not mind guaranteeing their company's debt and risks as long as they are never really at risk of loss ' in other words, their worst case out-of-pocket amount is zero. This may sound obvious, but not always intuitive. Simply by showing the numbers or highlighting the real downside risk to the guarantor (vs. the perceived risk), you may bring value and clarity to the transaction that others won't.

One strategy for individual guarantors is to assure that the amount of debt guaranteed never exceeds the liquidation value of the assets of their business, taking into account the priority of liens and repayment if the business went bankrupt. If they are OK with taking some financial risk in addition to the amount that can be covered through liquidation of the business, then calculate the same liquidation value and add the acceptable amount. Once you have helped the guarantor establish a limit, suggest that he have his controller, bookkeeper or accountant provide a monthly or quarterly estimate of liquidation value based on their actual financial statements. This will provide him and you visibility so he can track and manage the risk being taken.

If you are in a position to shape the deal, use the information above when negotiating the terms of the guarantee so they fit the situation and limits. You are helping the client manage his risk and differentiating your deal from others. Below are some of the deal points that you should consider.

1) Guarantee of Payment vs. Guarantee of Collection ' the most common guarantee is that of payment. This typically means that if the client company does not meet the agreed payments, the lender, lessor or bonding company can demand payment directly from the guarantor without pursuing further action against the company. A fallback position to soften the impact for the guarantor is to offer a guarantee of collection. This arrangement typically requires the lender first exhaust its options against the company before it can demand payment from the guarantor. So if the guarantor never borrows more than the liquidation amount of his company's assets and he made a guarantee of collection, he could avoid ever having to write a check from his personal assets. Alternatively, you may negotiate a guarantee that only provides protection in the event of fraud or wrongdoing; this is sometimes referred to as a fiduciary guarantee.

This type of concession makes sense when you have a reasonably strong client company ' but the collateral is specialized enough that having the principle(s) of the firm engaged in an unwinding (worse case) may make the difference in keeping your deal whole.

2) Limit Scope and Collateral ' Another strategy to focus the guarantee and provide comfort to the guarantor is to limit the scope of the commitment, excluding recourse against his house or other specific property. There are specific laws around the topic of a homestead exemption that the guarantor may see as a compromise by your firm ' that in reality may really be clarification of a right that he already has. Making it explicit in the guarantee documents may provide additional comfort for the guarantor (and his spouse). It may be easier or more palatable to obtain a pledge or lien against specific property, or a pledge of the stock in the business, than to obtain a blanket guarantee.

3) No Spouse Signature ' A hot button for many business owners is having to obtain a spouse's signature for a guarantee. It forces owners to have conversations that they would just rather avoid. From your perspective as the lender, this can be problematic depending upon your objectives and the laws of the state of legal venue. Tread carefully. Obtain financial statements showing only his individually owned assets and liabilities to determine the reasonableness of a single signature. In many cases, the decision of having both signatures goes back to the fundamental reason for obtaining the guarantee in the first place.

4) Set Limits ' quantify the limits on the amount of the guarantee either in relative terms or absolute terms. For example: The client company may have a line of credit with $2 million total availability. Set limits to allow the guarantor to manage the risk to a percent of the outstanding balance or an absolute maximum; maybe 20% or up to $200,000. This is particularly appropriate with multiple owners whereby each desires to limit his exposure based on percentage ownership. Additionally, you may negotiate to reduce the guarantee as the performance of the company improves. As an example: The company has a debt-to-equity ratio of 3:1 post-financing; negotiate to reduce or limit the guarantee when the company's debt-to-equity ratio falls below 2:1. Also consider having the guarantee become less onerous over time, based on a continued relationship with your financing company. For example, a guarantee of payment could convert to a guarantee of collection after a couple of years of a spotless repayment record, or the guarantee could burn off gradually.

5) Adequate Insurance ' Advise the guarantor to obtain insurance covering the collateral for the loan or lease based on limits commensurate with the cost to replace the supporting property. Neither your firm nor the guarantor want to be caught off-guard in the event of theft or hazard ' resulting in the guarantor being obligated to personally pay for lost inventory or property that is part of the deal. Also, encourage the guarantor to purchase business interruption insurance (business income and extra expense coverages) with limits that are in sync with the amount of time and additional expense it would take to restore normal operations after a disaster. In addition, consider fraud insurance to protect against an officer or employee stealing from the company and incurring debt on a line of credit. Broad form property insurance usually covers only a small amount unless specifically added to the policy; increase this policy limit to match the credit facility limit.

Historically and from a practical perspective, guarantees have been form documents that were difficult to negotiate or to get much movement by the lender. Finding ways to compromise or provide additional value as a lender may be just the trick to win new clients that have financing alternatives.

Independent Advice

Lastly, encourage clients to get solid independent advice from experienced legal counsel and financial experts. Taking an honest-broker approach to establishing a long-term relationship with clients is good for your business and theirs; it is easier to do business when everyone is informed. If a client has partners or other shareholders, they may need separate counsel representing them vs. their company. The nuances of the guarantee are specific to each guarantor and their circumstances ' have them get qualified legal advice to assure the terms and concepts fit their situation and work for you as the lender or lessor.

Kenneth H. Marks is the founder and a managing partner of High Rock Partners, providing growth-transition leadership, advisory and investment services. He is the lead author of the Handbook of Financing Growth published by John Wiley & Sons. Marks may be reached at [email protected].