Should you guarantee your company’s debts? Should you require your delivery customers to personally guarantee their trade credit? Why do lenders want guarantees? What should it be worth to get rid of a guarantee?
These are all very valid questions that rarely get straightforward answers. First, let’s cover the legalities of a personal guarantee. A guarantee only kicks in when the original entity has defaulted on payment. Typically, in this “push-has-come-to-shove” situation, it’s going to take legal action to force a guarantor to pay up.
The first fact that will dictate whether a guarantee is enforceable is the issue of economic benefit. There must be a clear, established relationship between the guarantor and the owing party and the guarantor must have received or had potential to receive economic benefit. Essentially, this means that if some unrelated party guarantees a debt, the guarantee is worthless.
Next, the guarantor must have the ability to pay the debt. If the guarantor has no assets and no cash, he won’t be able to make payment. Also bear in mind it usually takes a judgment to get paid.
Why do lenders want guarantees? It is one way to reduce risk. They feel that a legitimately guaranteed loan is more likely to be paid than one without the guarantee. So, when considering trade credit guarantees, if a customer is in a credit crunch, and you are the only trade account he has guaranteed, you may get paid before the other trade creditors. With that said, if your customer is a flake, he’ll figure he won’t pay regardless of any guarantee, so it will be worthless.
Next, should you guarantee your company debts? When a guarantee buys you a cheaper interest rate, would not jeopardize your personal financial security, and does not interfere with your estate planning, it can be a good cost-reduction measure.
As with any loan decision, the way to determine the best choice of financing is with a net present value analysis of all loan options accounting for all terms and costs. By comparing the NPV result of loans with and without personal guarantees, you can see the actual dollar cost to selecting a loan with no guarantee.
For instance, if you used NPV analysis and found a $45,000 difference on a $1,000,000 loan financed over 20 years, that would equate to about $2,250 extra paid per year to avoid the guarantee or $187.50 per month. You can then easily decide if the monthly premium is worth it.