Ferris & Britton


	Home \| Contact Us \| Site Map \| Help

How to Protect the Business Owner When Obtaining Financing
By Gary T. Moyer

Owners of a business are not powerless to protect themselves when the terms of a financing transaction are being negotiated, and this article will explore some of the techniques available to protect a business owner in financing transactions.

One protection is likely to be familiar to all readers of this article, but it nonetheless will be briefly mentioned because of the surprising number of business operated as sole proprietorships or as partnerships in which all of the partners are individuals.

This obvious protection is for the business owner to choose a type of entity in which to operate the business that will limit the owner's exposure to personal liability. Examples include a corporation, a partnership of corporations, or a limited liability company. (Legislation making California the forty-sixth state to recognize limited liability companies was passed into law on September 30, 1994.)

However, most business owners know that simply transferring the business to such an entity is not a panacea, because virtually all financial institutions will require some or all of the owners of the entity to personally guarantee loans made by that financial institution to the entity. The financial institution is understandably risk adverse, and they want to shift to the business owner the risk of the business or its assets declining in value.

In this situation, the financial institution will request that some or all of the business owners sign an agreement called a "guaranty." The business owner thus needs to focus on the terms of the guaranty, and seek to negotiate some or all of the protections discussed below into such guaranty.

Where there are several owners of the business, the financial institution will likely ask each of the business owners to guarantee the full amount of the debt. Thus, if there are five equal business owners and $1 million is being borrowed, the bank has the business on the hook for $1 million, as well as the five business owners on the hook for $1 million each.

If the business did not pay the loan, the financial institution could collect the full $1 million from any of the five business owners. It would then be up to the business owner who paid a disproportionate amount to sue the four other business owners to seek reimbursement of the disproportionate part of the payment. In other words, the business owners are jointly and severally liable for the debt.

The most common technique to limit personal liability in this situation is to set a maximum that the business owner will be liable for under the guaranty, with such amount usually equal either to a negotiated amount (e.g., $250,000) or to the amount borrowed multiplied by the business owner's percentage ownership in the business. A variation of this technique is to create a floor on the guaranty by carving out assets that are not subject to enforcement of the guaranty. It could be a formula, such as a provision that the liability of the business owner shall not exceed 85% of the difference of the fair market value of the business owner's non-business assets less the business owner's liabilities. Alternatively, specific assets could be excluded, such as the residence, automobiles and a specified portion of liquid assets of the business owner and his or her family.

Financial institutions often seek to have business owners sign a guaranty whereby the business owner personally guarantees each and every loan from the financial institution to the business owner, including future loans. This is generally known as a continuing guaranty. Continuing guarantees can be revoked by the guarantor at any time, but only in respect to future transactions, unless there actually exists a continuing consideration as to such transactions which the guarantor does not renounce.

To summarize, there are various techniques available to a business owner to limit his or her personal liability for debts of the business. With respect to a personal guaranty, it is best to negotiate those limitations into the guaranty when the business owner is in a position of strength, i.e., when the terms of the loan are still being negotiated. The business owner who is borrowing from a financial institution does not have to simply accept verbatim the loan documents proffered by the financial institution.