Most small business owners soon find out that it’s difficult to get credit in the name of their company without providing a personal guaranty. A personal guaranty is exactly what it sounds like: the business is allowed to buy supplies on account, or borrow money from a lender, but the owner must promise to pay the creditor in full from his or her individual assets if the business can’t do so.
Personal guarantees are common in many business transactions such as credit applications, real estate leases, bank loans, and bank lines of credit. To be enforceable, a personal guaranty must be in writing and signed by the person who is guaranteeing payment on behalf of the business.
As with other written contracts, it is important to read the guaranty carefully to understand the liability of the guarantor and any requirements that the creditor must meet before demanding payment on a debt. But a contract is a contract, and the creditor is legally entitled to enforce a personal guaranty according to its terms. This means the seller may remain legally responsible for the business debt even after a sale of that business.
Most sellers don’t want that liability because they will no longer control the success or failure of the company. This often results in negotiations with the buyer to take on financial responsibility for the guaranty. But the personal guaranty is a contract between the seller and the original creditor, so any release of the seller requires written consent from that creditor.
Savvy creditors will not release the original guarantor unless assured that the new buyer is at least as financially sound a risk as the seller. And even if the buyer has a greater ability to pay, the creditor is not required to agree to release the seller, so it is common for a seller to retain at least some personal liability for debts of the business.
In cases where the creditor won’t agree to release the guarantor, sellers often request an indemnity and hold harmless clause that obligates the buyer to take full responsibility for payment of any amounts that might become due under the personal guaranty. Keep in mind that a hold harmless agreement is little more than a written promise to pay. If the buyer lacks the financial ability to do so, the seller may still have to make payments under the guaranty.
Before agreeing to a hold harmless agreement in lieu of a release from the creditor, the seller should conduct appropriate due diligence regarding the buyer’s ability to pay. If the buyer is a separate legal entity, it may be appropriate to require a personal guaranty from the principals of the entity. If the buyer is an individual without sufficient assets to allay a seller’s concerns, the seller may wish to request a personal guarantee from a third-party instead.
ALLOCATION OF LIABILITY
Regardless of how the terms are negotiated, it is critical for the seller and buyer to identify all personal guarantees relating to the business and have a clearly documented agreement regarding allocation of liability for those guarantees.
All business owners invest in their growing businesses and hope that their hard work will ensure a comfortable retirement. But changing times, technological advances, and an increasingly global economy may wreak havoc on those plans.
In the next Business Killers vignette, a sleepless older man is sitting up in bed. His wife asks him what’s wrong and he confesses that he might not be able to sell his business to fund their retirement. Apparently a large international firm has entered the market and is buying up raw materials and undercutting prices. As a result, the prospective buyers that had expressed interest in his company have pulled back. And while he could sell out to the big international competitor, they would only give him about half of what he thought his company was worth. Any retailer who’s dealt with a big box store or a Wal-Mart entering the neighborhood knows that this scenario isn’t good for a small business owner. Now he’s kicking himself for not listening to his financial advisor, who has been encouraging him to diversify his assets instead of plowing all his money back into the business.
Future-proof Your Business
Two takeaways are worth noting. The first is what my friend Steve Bergman, a consultant with Teleconvergence, calls the need for “future-proofing” your business. Steve has developed a few maxims to help business owners understand trends that may affect their industry. According to Steve:
• if it’s wired, it will become wireless;
• if it’s fixed it will become mobile;
• if it’s wireless or mobile, it will become intelligent;
• if it’s intelligent, it will become shared;
• if it starts as a product, it won’t stay that way indefinitely; in turn it will be
• bundled, then
• interfaced, then
• integrated; then
• combined to become multi-functional
• then become firmware
• then become software
• then lose all identity and become an application or a service.
A Failure to Plan is a Plan for Failure
In the Business Killers example, it may not have been obvious that this particular international firm would get into the business, but it probably didn’t take a lot of insight to figure out that competition is always a potential threat. The second is that regardless of how successful a business you are running, you need to begin planning your exit strategy years in advance of the actual retirement.
Had our business owner heeded his financial planner’s advice, he would have set aside money to help fund his retirement from the outset, thus leaving him less dependent on a sale of the business. In addition, he would have been working with a business broker or perhaps a business coach or consultant to develop an exit strategy that might have avoided the “fire sale” that he is likely facing.
Again, a failure to plan has turned into a plan for failure. Don’t let it happen to you – whether you are just starting a new business or nearing retirement, it pays to talk with professionals who can help you realize the wealth that you are creating.
Many small business owners want to know what their business is worth. The answer, as in any transaction, is what a buyer is willing to pay. And what a given buyer will pay may depend on a host of factors regarding the particular industry and the condition of the business. For detailed information, it pays to use a business valuation expert such as Dan Gilbert at Gilbert Valuations, LLC.
Business brokers often use shorthand formulas based on multiples of earnings to project a potential sales price. This makes sense because earnings are more relevant than gross sales. And buyers tend to view the purchase of a business as an investment. Using a multiple of earnings formula allows the buyer to have a sense of how long it will take to recoup that investment and begin making a profit.
Simple enough so far, but how to know what it means for a particular business? For starters, which earnings do we mean? Last year’s? A rolling average of past earnings? Current earnings? Or projected earnings that forecast the future? Assuming we can agree on the right time period to measure, the next question is how do we calculate those earnings? Most accountants commonly use a formula that measures earnings before interest, taxes, depreciation, and amortization (“EBITDA”). It sounds complicated, but the goal is simple – finding out how much cash the business generates from operations.
After deciding which earnings and how to calculate them, the third question is what multiplier to use? For most businesses, it’s somewhere between 3 to 5 times EBITDA. For a buyer, this would mean recouping your investment in 3 to 5 years from profits of the business.
The bottom line is that rules of thumb are simply a shorthand way to “guesstimate” a possible sales price. Many factors come into play, and there’s no substitute for using a qualified professional to evaluate the particulars. As they say, actual mileage may vary.