When it comes to financing the acquisition of equipment, starting a new diagnostic imaging center, or borrowing money for working capital purposes, the subject of guaranties invariably arises. For the most part, the concerns and questions revolve around personal guaranties, but corporate guaranties are often at issue as well. This article is intended to provide you with some practical thoughts, meanings, and advice about guarantiesboth personal and corporate.
However, before jumping right into guaranties, what they mean and how to deal with them, it is important to review what a borrower is and what a lender is.
A borrower, in general, is fairly straightforward: it is typically some sort of legal entity owned by one or more people and/or one or more corporate entities that has been created to start a new business or buy equipment or some other business-related venture. The borrower, or borrowing entity, is, by definition, the primary guarantor of the money being borrowed (“debt”). As a result, many borrowing entities have been created to keep the guaranty at that level and minimize the financial liability of the equity owners of the borrowerwhether they are individuals or corporate entities.
A lender, which can be a bank, an independent third-party leasing company, or a manufacturer’s finance company, assesses risk and loans money. The lender assesses the risks inherent in a given borrower by assessing the borrower’s current business operations and financial results, as well as its business plan or whatever the vehicle is that is used to describe what they want the money for and, of course, how much. The “what” can be starting a new business practice, buying equipment, acquiring another practice or business, and any one of a number of other purposes. The “how much” is always important and is typically stated as part of a budget presentation. Once that risk assessment is complete, then the lender will tell the borrower how much money they will lend, at what price, and under what terms and conditions.
There is usually a term sheet that precedes this assessment, and the lender will generally do their best to meet the terms and conditions as outlined in the original term sheet by the lender’s salesperson. It is not unusual, however, that circumstances change or something cannot be proven and that the terms and conditions, as well as pricing, change in the end. Lenders, be assured, full well know that borrowers want to minimize guaranties, particularly, but not exclusively, personal guaranties.
What follows are the nine most frequently asked questions about guaranties – and answers.
1. What is a guaranty?
The word “guaranty” is synonymous with security, warranty, and collateral. The word can also be used in conjunction with both security and collateral. In the finance world, a guaranty is another way of securing a transaction in the event of a business failure experienced by the borrower. There are other ways of securing a transaction and those will be discussed later.
Here is an example of a circumstance where a lender will require guaranties: if the entity seeking to borrow money is not credit worthy (it is a new project or it is an enterprise with little or no track record and no cash flow), then the proposed lender will seek ways to secure, collateralize, and guaranty the repayment of debt, especially in the event of a default. These ways include:
- Obtain a security interest or lien on not just what the lender is financing, but on all assets of the borrower (including accounts receivable).
- Take a collateral assignment of any material contracts (service provider contracts that the borrower may have with a local hospital, for example, to provide a specialty service).
- Require personal and/or corporate guaranties.
The first two ways are generally straightforward, generally not terribly contentious, and usually both required and expected. The last one, however, personal and/or corporate guaranties, is where the most angst tends to come from – particularly on the borrower’s side.
2. What else is necessary to know about guaranties?
Additional terminology is used to distinguish guaranties:
- Joint and several, and several guaranties. “Joint and several” guaranties mean that if one of your partners who is also guarantying the business debt along with you cannot come up with their share of their payback to the lender at a time when the lender requires it to be paid back (that is after your business has failed), then you are liable for the entire amount even though you may own, for example, only 50% of the business.
“Several” guaranties are much more appealing in that you are liable only for your pro rata share ownership interest of the business and that’s it. If you own 50%, you are required to pay only your 50% of the debt obligation if the business fails. Your partner is responsible for their 50% and if they do not have the funds available at the time it is requested by the lender, that is not a problem that you are legally required to solve.
- Limited guaranties. It is also true that guaranties can sometimes be limited to a certain portion of the amount being borrowed. Some lenders require only a guaranty for that portion of the debt to be incurred that is not a hard asset (equipment). For example, if you borrow $300,000 for renovating the space you are going to house your business in and another $1 million for the equipment, some lenders will require guaranties only on the $300,000 and if they also offer it on a several basis, then, if you own 50%, you are guarantying only $150,000. That is a far cry from potentially being personally liable for $1.3 million if the guaranty was for 100% of the amount borrowed and on a joint and several basis.
- Collateralized guaranties. There are very real differences between “collateralized” guaranties and “noncollateralized” guaranties. Collateralized guaranties mean that you secure your guaranty with another asset that you ownperhaps it is a home, a second home, a brokerage trading account, or another business that is owned. It is likely to be substantive and, in the event of a business failure, the lender can sell the house and get the proceeds or cash in the brokerage account in an effort to satisfy the guaranty that was provided in support of the borrowing for the new business. Most borrowers obviously want to try to avoid that, but it is not always possible. Noncollateralized loans do not relieve total liability by any means, but it does make it harder for the lender to force the borrower to pay obligated amounts in the event of a business failure, assuming the borrower is not prepared to stand up to their obligation in the first placeand I would certainly not recommend that.
3. Are there examples of borrowers who will not be required to provide guaranties?
Another way of phrasing the question is to ask: Are there examples of borrowers who can “stand on their own?” And the answer is: Of course, there are.
Take the 15-year-old radiology practice with a dozen physician owners, a strong cash-flow position, and a positive debt repayment historya lender will “kill” to provide a loan to an entity like that. The presumption is that the entity borrowing the money, especially when you add in the security interest that the lender will have in the equipment being acquired and whatever else is involved, will well be able to stand on its own without further guaranties of any kind.
4. What if the borrower cannot “stand on its own?”
In the alternative, if the borrowing entity is not strong enough to stand on its own, then the lender will likely require guaranties and/or other support or enhancements for securing the project. Examples of “not strong enough” include:
- If it is a brand-new entity.
- If it has too few years in business.
- If there are too few physician owners.
- If there is not enough cash equity in the project.
Examples of other support and enhancements include, beside guaranties, collateralizing the guaranties (as discussed previously), requiring a stand-by letter of credit (to be discussed), crosscollateralizing the loan with others that the lender may have made to you or to directly related parties to you in the past, and other creative ways designed to tie you closer to the project and thereby ensuring that your interests are directly aligned with those of the lender.
5. How can guaranties be minimized?
Even assuming that the project you are undertaking is a start-up and that your entity does not have a track record, there are definitely ways to minimize guaranties. Some of which you will find palatable and some perhaps not.
- Add equity to the project. Let’s say that what you are providing to the project as equity amounts to a 25% equity contribution toward the total cost of the project. A lender may think that amount is acceptable, but it may not be enough to eliminate the guaranties. If you increase the equity amount to 30% or 35%, you may well have a much greater chance that the lender will limit, if not totally eliminate, your need to provide personal guaranties.
- A stand-by letter of credit can be a good alternative to cash to improve the risk of repayment. The stand-by letter of credit will come from a bank and will be written in favor of the lender. If the business fails, the lender is guarantied to collect on the proceeds of the letter of credit. You, of course, have to arrange for the letter of credit and pay for it.
- Collateral assignment of contracts. If there are contracts that your business has for providing certain types of services (mobile MRI, for example) to a hospital or a radiology practice that does not have its own MRI, then the collateral assignment of that contract has value to the lender. If the borrower defaults on the loan, the lender can step into the shoes of the provider or arrange for a new provider to carry out the services under the terms and conditions of that contract. That contract has positive cash-flow implications for the lender, since it is another way for the lender to keep debt repayment dollars flowing to them.
6. What is a “burn-off” mechanism and how does it work?
There are some lenders that will allow guaranties to “burn-off,” be released, or be reduced under a certain set of circumstances. Those circumstances usually involve the passage of time, prompt payments during that time, no other events of default will have occurred, and the business will have to meet a variety of cashflow covenant tests designed to substantiate the fact that the business is doing well and that the start-up business has matured. It may look complex, but it’s not.
7. Can nonguarantied financing be obtained for a start-up project?
The answer is yes. There are lenders out there that finance start-up projects with strong business plans and owners who have a demonstrated track record from their past as, perhaps, employees of other companies in directly related businesses. However, the risk that these lenders take is often reflected in the interest rates that they chargewhich, in my opinion, is only fair. If they are taking a risk that only the cash-flow projections of the proposed project, along with the liquidation value of the equipment and other assets that they have secured, will be enough to repay their debt in the event of a business failure, then they should be paid a higher interest rate. You have all heard a phrase that goes something like this: the higher the risk, the higher the reward. As entrepreneurs, it is part of your own make-up and philosophy to understand this risk axiom.
8. What impact can due diligence (underwriting) have on the transaction structure?
Keep in mind that a lender’s underwriting staff will always look at the worst-case scenario for a given financing and they will always seek to ensure that the structure of the transaction (the terms and conditions under which the lender will provide the debt) takes into account the best ways to protect the lender’s interest. That does not mean that all lenders will structure every transaction using all possible permeations of protection against loss. That is what competition is all about. As a buyer of financing, you should seek the lender that can best meet your needs, and that can often come down to which lender will offer the best structure, in addition to the best rate and the best repayment terms, from your perspective. It is always a good idea to shop around for financing.
9. Are interest rates the only measure to consider?
The answer is a resounding no. Interest rates are important, but they are not the only measure of whom a borrower should select to do their financing with. Experience, trust, and other transaction structure elements are important factors to consider. Loans that require guaranties generally have lower interest rates than loans that do not require guaranties. It is necessary to assess the trade-offs for having a limited or nonguarantied structure with a lender. It can definitely come down to dollars and centsyou can, and should, calculate what the premium cost is for having a nonguarantied (personal and corporate) transaction structure. Are the dollar savings worth it? Is the dollar cost worth it? Assess the trade-offs and make an informed decision.
As is true for most things, learn to understand what the right questions (and answers) are for arranging debt financing for a particular situation.
When it comes to guaranties, borrowers must know what they are willing to offer and accept, what they are willing to trade off, how much they are willing to pay for that trade-off, and what are the most important issues to both borrowers and investors or partners.
It may be found that the best interest rate comes with a guaranty that is on a several basis and, further, that it can be “burned off” after less than 3 years. Having a contingent liability on a personal balance sheet of, for example, $100,000 (a borrower’s pro rata or “several” portion of the total guaranty amount) may be palatable, especially if the interest rate premium for a nonguarantied structure will cost the project an extra $200,000 over the repayment period. On the other hand, a borrower may be well prepared to pay the premium, which may be nowhere near $200,000, for a nonguarantied transaction structure.
Robert S. Goodman is managing partner, The Mansfield Group, LLC, Westampton, NJ