SME directors should be careful when lenders ask for personal guarantees

Personal guarantees beware of sharksObtaining business finance from mainstream lenders, such as banks, has been a problem for SMEs for a number of years, despite various Government initiatives and schemes that were supposed to help.
Even if the bank agrees to a loan request it may be at a very high interest rate or under specific conditions, such as a requirement from the company’s directors to provide a personal guarantee.
However, it is not uncommon for alternative lenders to also request a personal guarantee, and there is some evidence that such conditions may be on the rise, depending on the health of the business and the type of finance the SME is asking for.
Certain SMEs, such as start-ups, sole traders or those with inadequate records to demonstrate the viability are understandably seen by finance providers as high risk and therefore unlikely to be able to get funding without a personal guarantee.
But many directors have only a hazy understanding of the obligations they are taking on.
Read the fine print of a proposed personal guarantee
The Daily Telegraph last year published the results of a survey of 510 small businesses which found that 55% did not know what a personal guarantee was and 21% thought “that it meant a business owner would have to pay the money back on time to the best of their ability”.
Put simply, when a director provides a personal guarantee to a third-party creditor it means that they are agreeing to pay instead, if their company defaults on a loan repayment.
However, this means they are putting their personal financial security on the line, especially if the company is heading for difficulties or is insolvent.
While it may seem acceptable when the company is growing and doing well, circumstances can change, so it pays not only to scrutinise the fine details of any agreement but to also to get advice.
A personal guarantee is only enforceable if it is in writing and has been signed by the guarantor.
Make sure you know the difference between a personal guarantee and an indemnity which in practice tend to be very similar, but the latter is sold as nothing to worry about.
Check also whether it is for a specific loan or for an indefinite time beyond the loan when future loans might be taken out, and sometimes by new directors long after you have left the company.
It makes sense to edit the lender’s documentation to add clauses such as limits to the guarantee, both amount and duration.
It also makes sense to clarify if the guarantee covers the principal of the loan or loan plus any recovery fees which can be considerable.
It is recommended that you at least check the following:

  • What exactly constitutes a default that triggers the guarantee?
  • Is the amount of the guarantee capped?
  • What is the limit of liability of the guarantee?
  • What is the time limit of the guarantee?
  • How do I terminate the guarantee?
  • Will notice be served or can they seek payment on demand?
  • How will the personal guarantee be enforced?
  • What are the terms for any remedy period?
  • How you will settle the guarantee if it is demanded?

While there are obvious benefits for a lender to obtain a personal guarantee, most guarantees are given as a means of getting credit or borrowing money. It makes sense that the guarantor both understands the risks and also considers alternatives. Growing companies generally need finance, especially when they are growing but cash flow can be improved by getting paid swiftly by customers and agreeing delayed payment terms with suppliers. It may be that a business should not grow so rapidly that it is constantly short of working capital.
Finally, it is worth remembering that if a personal guarantee is called upon then the consequences can have a significant impact on the guarantor’s personal finances, and in extreme circumstances it can lead to the prospect of bankruptcy and even losing the family home.

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