PERSONAL GUARANTEES
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.
LIABILITY
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.
CHANGING GUARANTORS
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.