Director's Guarantee - What & Why?

Assisting businesses of all shapes and sizes with their finance requirements means we are often in situations where the funders we work with will ask for Directors Guarantees as a condition of any finance acceptance. This can be an emotive subject so we thought it would be helpful to explain why funders ask for it, when they are likely to ask for it and what exactly are the responsibilities if you agree to one.

Some people think that the request for guarantees will either be mandatory for all lending from any particular funder (and that is true in some cases) or more often a point of negotiation. I have to say however that in most cases there are valid and reasonable reasons why its being asked for.

Firstly, if you are a sole trader or partnership you will know that you are personally liable for any debts of your business, so the finance company or bank wont need to ask for any form of guarantee as you are already "on the hook" so to speak.

Director's Guarantees, or Personal Guarantees, as they are sometimes called are only relevant in the case of finance required by limited companies.

Lets break it down to its basics. A limited company is a separate legal entity to the directors of the company and in the normal course of things liability of the directors is limited to what they have invested in the business, so that if the limited company fails the directors are personally not responsible for any costs or debts.

Its an important fact to remember that, as a separate legal entity, when a limited company is requesting finance then it is the limited company, and only the limited company that is initially considered in terms of underwriting the risk. The fact that a Director may be personally a millionaire is irrelevant, at least at this first stage of underwriting.

So the funder will consider the strength or otherwise of this company as it is TODAY.

The key things that are looked at are:

 â– Net worth of the business (deducting any intangible assets) and comparing this to the size of the funding request
 â– Turnover over the last 2 years - is it increasing or decreasing
 â– Profit - again is it going up or down
 â– Cash in hand - a key component of considering serviceability
 â– Gearing - what is the ratio between interest bearing debt and the net worth of the business
 â– The Asset to be funded - what is it and what is its likely forced sale value in the event of repossession
 â– Age of business - any companies established less than 3 years can expect to be asked to provide directors guarantees for any borrowings.
There are other factors that are also considered but these are the key points and in answering these you can determine whether a funder will need the Directors to personally support the company borrowing by providing a guarantee.

Net Worth of the Business

Check your bottom line on your balance sheet, deduct any intangibles like Goodwill and if the figure you have left is less than the amount your are looking to borrow then a bank or funder can reasonably claim that the limited company on its own is not strong enough to have facilities agreed without guarantees. They would be technically lending the business more than its worth, and in this context you should expect to be asked for guarantees.

Turnover

A good indicator of a firms performance, but on its own would not be a determinant factor. A growing business may have a weak balance sheet or other issues that could mean they would still be asked for guarantees, conversely a dip in turnover for a strong, well established business, will not necessarily mean that guarantees would be asked for.

Profit

As with turnover, on its own not the most significant criteria but is looked at closely to form an overall view. A reduction in profits or even an occasional loss will not necessarily mean that guarantees would be asked for.

Cash in Hand

The likelihood of guarantees being required diminishes greatly the larger the cash reserves of the limited company, and by contrast heavy reliance on overdraft is likely to bring in the need for personal guarantees.

Gearing

Add up all your interest bearing debt (overdraft, loans, HP etc) in your creditors section in your accounts notes and divide that by the net worth (shareholders funds) shown in your balance sheet, and you have your gearing ratio.

This is the calculation of "what you owe "as it relates to "what you own". A gearing ratio less than 1 means your business value is greater than its debts, and anything over 1 means your business is worth less than you owe.

If its over 1 you have a good chance of being asked to provide guarantees.

Special note - if you do this calculation and get "infinity" as your answer then you have a negative balance sheet and will definitely have to provide guarantees to secure any borrowing!
 
Asset to be Funded

This is probably the most important criteria of all. If you want to finance an asset that hold its value very well, or has a long working life, or has a very large second hand market or by putting down a very large deposit you reduce the likelihood of being asked to provide guarantees.
 
Try funding IT equipment or catering equipment that arguably has zero value in the case of it having to be repossessed and you'll find funders very reluctant to lend at all and certainly would expect the directors to stand personally in support of the deal.

So we have covered when they may ask for guarantees, now we'll explain why.

It boils down to one simple fact - Banks and Finance Houses do not plan to lose money. If they provide finance for an asset purchase they expect all their money back plus the agreed interest. When the money is passed over they lose control and the success or otherwise of a company is down to the people running it - the directors.
Now if the company is strong enough, as we have outlined above, funders will happily lend to them without recourse to the directors as their risk of them losing money is remote.

However if the deal is riskier, in particular where there are weak value assets such as IT involved, that could result in the funder losing all their money then they would expect the directors to be confident enough in their businesses strength to stand in support of the finance facility.

This is where issues can arise, for example well established firms may not be used to provide guarantees, and simply refuse to entertain the idea. That is fine as the funder will simply refuse to lend without them.

You see the Directors may be taking the view that - "we've never been asked before and we never give them on principle" and this is not an unreasonable position but the funder only hears "we want your money and we'll happily keep all the profits if the purchase proves a success but we want you to take all the risk if things go wrong. Oh and by the way, we're not confident enough in our businesses continued trading to personally support this borrowing."

You see how this can create an impasse.

And its a real shame as deals sometime fall at this point and they really don't need to when you look at what the guarantee actually is and what the responsibilities are.

The guarantee has been there to provide three principle functions. Firstly to provide confidence to the funder that the directors of a company are committed to and are confident in the limited company's success and future.

Secondly to act as leverage to ensure that a director does everything in his power to minimize any loss the funder may be faced with.

And finally, as the absolute last resort, to cover off any shortfall that may exist in the funding owed.

Its best demonstrated by considering a company in distress. Finance has been taken and now sometime later the company is facing liquidation.

The finance company has first recourse to the asset it has financed and this becomes the primary security. If they have to they can repossess the asset and sell it for as much as they can to clear off the debt. Often this may fall short and in these cases they would ask for the directors to make up any shortfall. If there is no shortfall, for example the amount owing is less than what the asset is sold for, then there is no need for recourse to the director.

It really is important to remember that the guarantee is the last piece of recourse and in many cases funders will work with clients to transfer agreements to a new company in the event of a phoenix business being set up, to allow business to trade as a new legal entity.

So that's an insight in to the How, What and Why's of Directors Guarantees. I hope you found it useful.

To  see how MacManus Asset Finance can secure funding for your business call us on 0845 3300 455.