Personal guaranties: The enemy of limited liability

The limited liability protections that corporations, companies and other business entities afford their owners is one of the driving engines of our entrepreneurial economy. As long as the owners mind certain formalities and steer clear of fraudulent conduct, the limited liability feature of these business entities will protect the owners from any personal liability with respect to their business activities. It goes without saying, that this dynamic by itself allows entrepreneurs to take risks they otherwise might not take.

Of course, many business transactions — some of them very common and crucial to operating businesses, such as the borrowing of money from banks, signing a lease or obtaining credit from a vendor — often require the personal guaranty of the owners of the business. A personal guaranty will make the business owner personally liable for a debt even if all other aspects of the transaction are run through the business entity, effectively gutting the limited liability protections of the business entity. While guaranties can differ on the details, in general, it gives a contractual counterparty the right to “step around” the limited liability protection and go directly after the guarantying owner.

From the perspective of a bank, landlord or vendor seeking to obtain the personal guaranty, these parties are looking for assurances that if the business fails or otherwise does not pay, they will have a “backstop.” These parties also often see a business owner’s willingness to sign a personal guaranty as a sign of commitment, with the owner “putting her money where her mouth is.” Banks and landlords will generally assume that each owner of a business enter into personal guaranties and will prepare loan and lease paperwork — assumptions like these means that you, as a closely-held business owner, need to be “on the lookout” for these requirements.

Personal guaranties do not come about by accident. They require the signature of the person from whom the guaranty is sought in their individual capacity (i.e. not as an officer, manager or owner of a business entity). Most of the time, the exact capacity in which you are signing a document will be obvious from the nature of a signature block itself, however, that is not always the case. Some vendor credit agreements, for instance, contain language which will invoke personal guarantees for “any natural person signing this agreement” regardless of the capacity indicated in the signature block.

There are multiple varieties of personal guaranties as well. Most common in small business transactions is the payment guarantee, which is a personal guaranty that a business will pay a debt. If the business defaults, the beneficiary can trigger the payment guaranty and immediately attempt to collect from the guarantor. The collection guaranty is a guaranty of collection, which requires the guaranty beneficiary to exhaust certain avenues of collection with the business prior to triggering the guaranty. “Joint and several” guaranties require multiple persons to fully guaranty the same obligation, meaning that each guarantor is liable for the entire guaranty obligation individually, at the option of the beneficiary.

A tool of convenience for creditors, joint and several guaranties can require an individual guarantor to ultimately become personally liable for liabilities of the business which are far beyond their relative ownership in a business. In that regard, the owners should negotiate an agreement among themselves, as to how the owners will divide the guarantor liability. This is frequently done through a “contribution agreement” among the guarantors that requires each to be responsible for that proportion of the guaranty liability equal to their proportionate ownership of the business.

While banks and landlords in particular view personal guaranties of owners as standard, it is always in a business owner’s interest to avoid, limit or otherwise scale back an obligation to personally guaranty business debt. Often, owners will run into the dreaded “bank policy” dead end, particularly with larger lending institutions. However, many smaller banks will be willing to be flexible regarding personal guarantees. The simplest way to start a negotiation like this is simply to make it an issue early in the application for and negotiation of the loan. Banks and landlords are sometimes open to limiting the amount of a guaranty: perhaps the business has enough assets to justify a cap on the amount an owner can become personally liable for under the guaranty. Often, a lender or landlord will allow a personal guaranty to “burn off” if no default has occurred over a period of time. Sometimes, a bank or landlord will allow a guaranty to termination if a business’ financial condition improves generally, or if the business reaches certain financial benchmarks.  Owners may also be confronted with demands that their spouse enter into personal guaranties as well, regardless as to whether they are involved in the business. For obvious reasons, this is something to avoid and may allow married couples to manipulate their assets in a way to better shield them from guaranty liability.

Personal guaranties can come about in obvious and not-so-obvious situations. As the owners of a closely-held business, you have already taken many steps to protect your business, and yourself, from liability, by doing things like purchasing insurance and operating through a limited liability business entity. Personal guaranties can degrade or punch through these protections. You should consult with your legal counsel when confronted with a request to enter into a personal guaranty. It is often worth pushing back.

This article is for general informational purposes only, is not for the purpose of providing legal advice, and does not establish an attorney-client relationship. You should consult with an attorney to obtain advice as to your particular issue or circumstances.