Is your lender asking for a guarantee? A guarantee is the assurance that you will fulfill a commitment or obligation. When used in lending, a guaranty is a legal covenant and financial promise that you will fulfill your end of the bargain in its entirety. Understanding your guaranty is crucial to any borrowing decision.
There are three main types of guarantees in commercial lending: Personal, Performance, and Validity. Depending on the transaction, it’s possible that lenders require a hybrid of the foregoing. In this article, we’ll explore these three guarantees in more detail, helping you make an informed decision on which one may be attached to your loan or facility.
Personal Guarantees
A personal guarantee means that you are irrevocably and unconditionally on the hook if your business defaults on the loan. If you’re married, the marital assets of you and your spouse may be subject to recourse. Depending on the assets pledged, your spouse may even be required to sign as a personal guarantor. With a personal guarantee, you could be liable for more than just the outstanding loan, such as the lender’s legal fees, default interest and damage. Some lenders are required, by state law, to limit the amount guaranteed personally, while others require the entire loan amount.
Personal guarantees are common when a loan is unsecured* (i.e. no securitization of a hard asset) and based on an individual borrower’s credit history. In lieu of no encumbrance or security interest however, borrowers consent to some degree of personal recourse . Instead of going after business assets, the lender can attempt to recoup their investment or principal outlay from your personal assets. Generally, creditors are not able to seize personal assets to satisfy business debts without a court-awarded judgment. Signing a personal guarantee allows creditors to pierce the “corporate veil” and pursue lawful remedies against a borrower personally. If you are starting a business or operating as a sole proprietor, we recommend that you consult with an attorney or financial advisor in regard to forming a Limited Liability Company or Corporation to shield your personal assets from your business’ liabilities.
Performance Guarantees
A performance guarantee is the assurance that you will fulfill your contractual obligations in a financial transaction. Let’s say your business sells $100,000 of its future receivables to a lender, in exchange for a lump sum of liquidity upfront . A performance guarantee might stipulate that you aid and thus perform in the delivery of those future receivables to the Lender. This ensures that the lender rightfully receives what it paid for. Performance guarantees build accountability and aligns interests of the parties involved.
A “Performance Guaranty” is also colloquially referred to as the “Bad Boy Clause” in commercial finance space. In terms of personal recourse, a creditor is typically limited in seizing a borrower’s personal assets, unless the borrower commits a prohibited act (“bad act”) spelled out in the contract and/or fails to cure a contractual breach in a timely manner. The old saying, “it takes two to tango” is very relevant to B2B financial transactions as some scope of a transaction is within the borrower’s control.
Performance guarantees can be used when Loans or LOCs are structured against inventory. For example, let’s say a lender takes a risk by advancing your company 90% of your supplier’s cost (the “Value Financed”). Your company would likely guarantee Repayment of the Value Financed when the goods are sold to your customers.. If you fail to deliver the Repayment when your customer purchases your goods, the lender may exercise contractual remedies or corrective action by citing a violation to your guaranty of performance.
Validity Guarantees
A validity guarantee is less comprehensive in scope and is primarily used in invoice factoring and purchase order financing. This type of guarantee certifies that the invoices being factored haven’t already been pledged to another company. Additionally, a validity guarantee confirms that the invoices are legitimate and collectible. From a lender’s perspective, there is reliance on the data you provide them.
The scope of validity guarantees can vary. For example, a lender might have a validity guaranty clause that states any receivable payments sent directly to your company must be forwarded to the lender that paid for those invoices. Validity guarantees can be an attractive option because they do not tie your personal assets to the loan in the event of a default.
Choosing the Right Guarantee
Which guarantee fits your business needs? If you are taking out an unsecured business loan, signing a personal or performance guaranty is common. However, if you are factoring receivables, you might need to sign a validity guarantee.
The financial instrument you are applying for will dictate the right guarantee for your situation. In many cases, you might have more than one guaranty, depending on the Lender’s recourse and riskiness of your commercial transaction. To learn more about how guarantees impact different lending solutions, reach out to one of our team members at Capital Source Group to schedule a free consultation.
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