Using Personal Guarantees to Reduce Risk of Nonpayment Aug 23, 2013
By Reed Morris
In our work preparing contracts or structuring deals for business clients we always discuss securing any obligation to pay. While the ultimate business decision is made by our clients, we advise them of all options available for securing payment obligations whether the business is a manufacturer, retailer, service provider or financial institution.
How does your business ensure that it will get paid? The short answer is: you can’t absolutely ensure payment. However, there are several things business can do to decrease the risk of nonpayment. Some industry-specific deals provide other means of securing payment, such as payment bonds used in construction or liens on property offered as collateral in commercial lending. In many other types of business deals a primary means of reducing the risk of nonpayment is through the use of a personal guarantee.
The personal guarantee means that, separate from the business, an individual (usually an owner or owners) signs an agreement that he/she will be personally liable to pay his/her company’s debt should the company default on its obligations.
LLCs and corporations generally do provide their owners with “limited liability” for the business’ obligations, such as business debts. Protecting the business owner from personal liability is one of the reasons business owners form corporations and LLCs. A personal guarantee steps around that limited liability protection and makes the guarantor personally liable for the business’ obligation. Many times the individual business owner has significant personal assets, while the actual business (particularly a small business or startup) does not. In our experience, if a business owner’s personal assets are put at risk, business debts are more likely to get paid
Personal guarantees provide multiple avenues for collection. Both business and personal assets are available to cover the debt obligations. During collection, for the guarantor, a personal guarantee can be a sobering reminder of what is at stake. Receiving a separate demand letter or being personally named in a lawsuit is often all the additional motivation that is needed for the business (or the guarantor) to pay what is owed.
In drafting such agreements we ensure that the individual guarantor is specifically made a party to the agreement and is personally liable for the business’ debt. A personal guarantee provision in a contract should clearly state that the sale, loan, or credit being given is expressly conditioned on the existence of the personal guarantee, and that the guarantee is a material part of the consideration or basis for the agreement. When the agreement is signed, the guarantor (the person providing the guarantee) may actually be signing the agreement twice, once as an individual, and a second time as the authorized representative of the business.
Mallon & Lonnquist, LLC, is a business and real estate law firm. Reed F. Morris is a Colorado business and real estate litigation attorney with Mallon & Lonnquist, based in Denver, Colorado. Reed regularly represents businesses and individuals in business transactions and disputes, from pre-filing through trial, and can be reached at rmorris@mallon-lonnquist.com.