For most small businesses seeking bank loans to finance projects, trade, investments etc. a common feature banks would ask for before disbursing a loan is a Personal Guarantee (PG).
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Some borrowers over look it and go ahead to sign without acknowledging its implications while some know its implications and still go ahead to sign. The common reasons for this is that borrowers just want to carry on with their financing objectives and don’t want to be bugged down by a seemingly innocuous request, which doesn’t posse an immediate risk. But personal guarantees are a risk, a huge one for that matter for those who give it without considering its consequences.
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What is a Personal Guarantee?
A personal guarantee is an unsecured promise from an issuer to a lender promising to repay a debt that a small business is owing after failing to meet up its obligations to its lender. It is basically an additional security for a lender in the event that the Small Business lacks the cash flow and assets to repay the bank completely in the event of a default. Considering that the money banks lend to individuals and businesses are depositors money an extra security does not seem unreasonable to most lenders.
Why does a bank need it?
Banks especially in Nigeria, love to have enough security over their lending and also love to guard them jealously. In Nigeria, Small Businesses and indeed larger ones are mostly owned or controlled by one or two individuals. Banks recognize this structural deficit and see it as huge financial risk since a business controlled by one is more likely to default than that with strong corporate governance.
So a personal guarantee is also an extra protection against the owner(s) or promoter(s) of a businesses whose decision can positively or negatively influence the operations of the business. In the event that the owner of business is not involved in the day to day running of the business then by offering his personal guarantee he has no choice than to pay significant attention.
What are the risks involved
By issuing a personal guarantee, you are basically putting up your net worth (assets less liabilities) in favour of a bank. So if for example you have given a PG in favour of a bank for a small business loan which has gone bad, the bank can come after you claiming rights to your personal assets including your house, cars, stocks etc. The lenders will still come after you even if your assets are still not enough to recover the loans. They will milk whatever they can from you.
When your PG’s are called in you can also stand the risk of being shut out from future lending for other businesses promoted by you.
When should I absolutely give a personal guarantee?
A PG should only be given to businesses that you have direct control over. Control could mean either you own the business or majority stake in it. It could also mean that you oversee the day to day running of the business either as the Chief Executive or as a member of the board of directors of the company. Other than these avoid giving a PG.
When should I avoid giving a personal guarantee?
As mentioned above, you should desist from giving a personal guarantee if you do not own controlling stake in a business. In addition to that, if a business no matter how small has proven to be self-sustainable and generates adequate cash flow, then a request by a bank for a personal guarantee can be declined. You must be a able to convince your bank by showing them that the existing cash flows of the business will not only cover the loans but that the bank is also likely to benefit from the ensuing deposits that it will receive from the business.
Getting the bank to accept this reason for a small business may be difficult depending on the effect of demand and supply. In an environment where banks are awash with cash and looking for sound businesses they can lend to, then it is logical that companies built on sound financial principles will get away with providing a personal guarantee.
Mitigating against Personal Guarantee
Considering the fact that PG’s are almost inevitable for small businesses if they are to access loans, issuers of a PG can exploit various options that can be used to mitigate the risk. One way is to limit the tenure to which your PG can be in place. For example you can negotiate a caveat that provides that your PG will expire immediately the business starts to generate revenues. You could also tie the eligibility of your PG to your involvement in the business either as a owner and/or a key promoter. Some people forget that their PG is in place long after they have divested interest and ownership of the business.
You can also spread the risk if you are not the sole owner of a business. For example an individual with less than 25% ownership of a business who provides a sole PG is at risk of loosing not only his investment should the business go down, he also looses personal assets. It is therefore advisable to ensure a collective corporate guarantee is obtained from not just you but other directors and major shareholders of the business.
You could also limit the amount you can put up as a guarantee. This could be done in a combination of ways all resulting in you limiting your exposure to a fixed amount that is compatible with your investment risk. For example if your business borrows N100million you could limit your guarantee to 50% of the loan. That way if the loan goes bust, you are only liable for N50million. You could also tie your guarantee to a percentage of outstanding loan rather than to a fixed amount meaning rather than say I guarantee 50% of N100m loan, you will guarantee 50% of the outstanding balance of the current loan. The advantage is that, in the event that the business has paid back say N30m of the loan then your guarantee is only limited to N35million instead of N50million.
It is also advisable to renegotiate loans with a view to changing its terms and conditions. Most lenders are usually favorably disposed to renegotiating the terms and conditions of a loan that is performing very well. So, if your business after obtaining the loan has consistently met its repayment conditions and the future outlook looks good, it is expedient for you to renegotiate the t&c of the loan. Whilst you may think the risk is low because the loan is been serviced regularly you should also be wary of the fact that things could go wrong someday. Therefore, if an opportunity arises for you to limit your risk such as the PG then you must use it.