April 26, 2021
As the pandemic passed its one year anniversary observance, a lot of entrepreneurs and business owners are learning firsthand what a personal guarantee on debt really means.
Most likely, it means that someone is demanding that you pay them money that you don’t have the means to pay. You personally promised to repay a loan to your business. But your enterprise has been either shuttered for months or operating at 50% of capacity or less; thus, there isn’t enough revenue to service the debt.
Doesn’t matter, says the lender: When you signed the docs, you affixed your signature agreeing that you’re on the hook, no matter what happens to your business.
Personal guarantees are common when borrowing money or leasing property to operate a business. We’ll focus on borrowing in this space today.
Unless your name is, say, Microsoft, Facebook or Apple, a condition of your business loan will almost certainly be your personal guarantee. For a small business operator, that can be devastating, because often no money has been taken out of the operation as the owner desperately tries to keep the ship afloat; the personal checking account may be as depleted as the store operating bank balance.
Banks, credit unions and thrifts (savings and loans) routinely require the personal signature, no exceptions. They want “skin in the game,” and bank examiners expect it. These lenders require it even from very good deposit and loan customers. Maybe, rarely, they’ll waive the contingency if a borrower puts up additional collateral for the loan, and cash is often the only option. If the bank backs away from spreading ink on the promissory note, it could demand, say, 75% of the loan amount in cash in, maybe a pledged CD that would immediately be applied to the loan on default by the borrower.
Which, of course, prompts the borrower to say, “What? Why would I want the loan if I have to tie up all of my cash!” Whereupon the loan officer smiles sweetly, responding, “Exactly, Mr. Smith. So just sign here on the note, and you can continue to keep your cash right here at the Second National Bank of Downriver Montana and withdraw it anytime you like.”
What about hard money lenders? They look at the collateral’s value, so they can forgo the guarantee with a conservative loan to value ratio, right? Generally, the answer is no. They too want that skin in the game. I’ve had discussions with some HMLs and heard some posit the possibility of redundant over-collateralization, such as, say, 20% LTVR on a piece of buildable land, maybe 45% on a free and clear rental property and possibly a lien against debt free equipment, but I’ve not seen such a scenario becoming reality.
In fact, at times, the hard money people can seem downright conservative, especially in a hot real estate market, like we’re currently experiencing. Many of these private lenders remember too well 2008, when 50% loan-to-value deals virtually overnight became 90% loans, and then, shockingly, deals that were way below water at 110%. So a lot of HMLs are hedging their bets, especially on super-jumbo residential properties that investors might be purchasing to flip. Some hard-headed capital sources are wondering if the Greater Fool Theory is not morphing into the Law of the Greater Fool: You know, “I’m a fool to pay this much, but I’ll find a Greater Fool to pay more.”
So one of these lenders might get a request for flash cash to buy a luxury home in Vail, with three contracts waiting to step up if the first buyer can’t meet some clause in the contract. That lender may decide not to rely on the contract price, or even a current appraisal. Rather, there may be an underwriting decision to ratchet down the value, maybe by checking the county assessor’s last “actual value” estimate, which most likely is quite a bit below the current hot market sales price.
We laugh at the joke that lenders want your first born as additional collateral.
But they would if they could.
Pat Dalrymple is a western Colorado native and has spent more than 50 years in mortgage lending and banking in the Roaring Fork Valley. He’ll be happy to answer your questions or hear your comments. His email is firstname.lastname@example.org