The problem with personal guarantees

Did you know that there are over 528,000 companies in New Zealand alone? Doing business through a company is very popular in New Zealand, because companies are very easy to set up and the compliance obligations that company owners face are fairly minimal compared to other countries.

One of the main benefits of establishing a company is that it has limited liability.  Shareholders in a company are only liable for the company’s debts up to the amount of their investment in the company. If a company’s debts exceed this amount, the shareholders do not have to pay the company’s debts. This provides peace of mind for company owners, knowing that if things go wrong, their personal assets will be safe.

However, this limited liability protection can easily be undermined if the owners of the company give a personal guarantee. A personal guarantee is a person’s legal promise to repay money lent to their business, or credit given to it. The person who gives the guarantee becomes personally liable for the debt, even if they operate their business through a company. The lender or creditor doesn’t even have to pursue the company first; they can go straight for the guarantor.

Personal guarantees are most likely to arise in 2 circumstances: firstly, when the business is borrowing money from a bank or other lender. If the assets in the business are insufficient to cover the debt (and any costs of recovery and inflationary risk), the lender will usually require a personal guarantee. This means that the lender has the option of recovering against the owner of the business if the business goes under. Lenders may even insist on securing any lending against the family home, or other personal assets. The borrower may have little negotiating power in this situation and may have the choice between giving a personal guarantee and walking away from the borrowing. It’s essential that you seek legal advice in this situation, so that you know what your risks and liability are.

The other situation where personal guarantees are common are with suppliers. Suppliers may agree to provide goods to the business on credit but may require the business owner to provide a personal guarantee of payment. Business owners often have more negotiating power in this situation and may be able to negotiate the terms on which credit is advanced. Some suppliers routinely request personal guarantees but may back down if the customer pushes back.

It’s worth considering whether there are other ways to provide security for the supplier other than a personal guarantee. It might be possible to register a security interest over the goods instead. Or you might be able to negotiate a limited term personal guarantee, which ends once you have demonstrated your company’s creditworthiness.

One of the ways to avoid the risks posed by a personal guarantee is to put your personal assets into a family trust. Assets in a trust will be safe, even if your personal guarantee is called on. Read our trusts e-book [link] to find out if a trust is right for you.

Don’t underestimate the seriousness of giving a personal guarantee. It may feel like a routine business practice, but it leaves you exposed to risk. A personal guarantee often covers both existing and future borrowing, so you may not even know the full extent of your exposure. Always seek professional advice before giving a personal guarantee: your advisor may be able to help you find other ways of providing security with less personal risk.