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Financing your Business.

How to protect yourself from signing unlimited guarantees.

You are a small or medium-sized business owner and you have just reached your objective, which is to finance the expansion of your company through your commercial banker. You plan to expand by purchasing equipment, leasehold improvements and inventory, which you propose to finance by way of credit line and term loans.

Your banker comes to you with the great news that your financing request has been approved and you can now get started on your expansion plans. The commercial account manager also advises you that one of the terms is that you will need to provide an unlimited personal guarantee.

Since you are keen to get going on the expansion, which will result in increased returns and make your company more competitive in the market place, you quickly agree to the banker's terms without a further thought.

You have just agreed to sign an unlimited guarantee, which means that you have personally -- and legally -- promised the bank that you will repay any of the bank's debt obligations that your incorporated business fails to repay. This also means that you, personally, have also agreed to cover any increases to the current level of borrowings of the company, assuming that the bank has your agreement or has provided you with a notice of the increased borrowing of the company.

At first glance, you may agree that as a business owner you should guarantee all of your bank financing so why not get the convenience of signing an unlimited guarantee to the bank since the bank can't claim more than they are owed anyway.

However, to expand your knowledge of guarantees and learn how to better protect yourself, consider the following four rules when signing guarantees:

1. You should provide a guarantee only to the extent that the bank identifies a risk, and in most cases it should be less than 100% of the financing.

2. A guarantee should always be limited to an amount. It is too convenient for a busy business owner to quickly, and dangerously, accept terms of increased financing while having an unlimited guarantee in place and therefore further increasing his or her personal risk.

3. It is important to understand the reasons why the guarantees are being requested.

4. If you understand why the guarantee is needed, you will know what you have to do to have them eliminated or significantly reduced over a period of time.

With this knowledge, you will have the opportunity to protect your personal assets by minimizing guarantee exposure. By limiting your guarantee you are limiting your personal contingent liability risk. Why take on more personal risk than you need to?

A guarantee represents a contingent liability to the guarantor and therefore every effort should be made to limit such exposure. To effectively negotiate with your bank to minimize guarantee exposure, you need to first understand why the bank needs to obtain a guarantee.

Why banks want guarantees

There are various reasons why a bank may need a guarantee. But the bottom line is the need to mitigate the risks they see within a certain financing transaction. There are two types of possible risks:

1. Qualitative risks: These are typically market or environment factor risks the company may face in meeting earnings objectives. These include start-up business risk, market demand risk, industry risk, environmental risks, competitive environment and managerial risks.

2. Quantitative risks: These are derived from the analysis of financial trends including adequacy of working capital, leverage position, debt servicing ability, sales and earnings results, and the security position of the bank.

Some of the most common quantitative risks that are important to your banker are:

* Tangible security being sufficient enough to cover the bank's position. Banks follow rigid rules as to how they value tangible security and as such they are designed to provide themselves with full coverage plus a safety margin.

* Balance sheet ratios. The company's Current Ratio (CR) & Total Liabilities to Tangible Net Worth ratio (TL/TNW) are within the bank's comfort range. The banker will also focus on liquidity, solvency and activity ratios and what these ratios consist of.

* Repayment ability risk of borrowing, having proven positive historical results. The banker will want to see that the company is able to service all of its debt obligations with a comfortable safety margin.

For every commercial loan of an operating company, these common quantitative risks should be addressed to the bank's satisfaction or mitigated to a certain degree. When any of these risks cannot be mitigated to the bank's satisfaction, you will be asked for some form of support through a guarantee or other security.

How to quantify guarantee(s) provided to the bank

One reason for the guarantee is because security is not sufficient enough to cover the bank's debts. For example, the quantitative and qualitative risks are all fine with the exception that the security value from the banker's perspective is lower than the amount of financing.

If this is the case, find out what the commercial banker calculates as a value of security and then use the following formula to calculate the guarantee amount: guarantee limit = total amount of financing less conservative value of security provided to the bank. So, for example, if the financing is for $500,000 and the security value based on the bank's parameters is $400,000, then the maximum guarantee limit = 500,000 400,000 = $100,000.

Another reason for the guarantee might be that the company's leverage is higher than the bank's comfort range. In this scenario, the guarantee limit formula should be equal to the difference in equity that would make the ratio 2.5:1, up to the maximum amount of a company's borrowings. For example, the company's TL/TNW ratio is 4:1 rather than the bank's comfort of, for example, 2.5:1.

Calculation example:

- Bank financing: $200,000

- Total liabilities (TL): $400,000

- Total tangible net worth (TNW): $100,000

- TL/TNW ratio = 4:1 (400,000/100,000)

To meet the bank's desired

TNW = 400,000/2.5 = $160,000.

Maximum guarantee limit = 160,000 - 100,000 = $60,000.

A third reason for a guarantee may be that the bank wants assurances that the company will be able to repay all of its formal obligations within a sufficient safety margin to allow for market and economy fluctuations.

If the reason for the guarantee is because debt-servicing ability is not proven or was weak the previous year, then calculate the guarantee limit as follows: First, find Out the Debt Servicing Coverage (DSC) requirement by the bank. This ratio is common in the industry and is the ratio of your cash flows (net income + deferred taxes + depreciation + interest + other non cash items) vs. cash outflows/debt repayment obligations (loans principal + interest payments + line of credit interest payments (based on approximate average annual usage) + capital lease payments + mortgage payments.) Keep in mind that there are other ratios that may also be used.

Then calculate guarantee limit by calculating the difference between your company's DSC based on last year's result and the ideal DSC for the bank's comfort level.

Calculation example:

- Bank financing: $200,000

- Normalized cash inflows: $175,000

- Cash outflows: $200,000 DSC = 175,000/200,000 = 0.875 times

(based on this example, the company is not generating sufficient cash to service its debt repayment terms).

Assuming the bank's comfort level of DSC is 1.25 times and that the company is forecasting strong increases in earnings to ensure that last year's dip in cash inflows will likely not be repeated, then the desired cash inflow needed would calculate as 200,000 X (times) 1.25 = $250,000. Maximum guarantee limit should then calculate as 250,000 175,000= $75,000.

If the reason for the guarantee is to mitigate qualitative risks, such as the company is a start up business, managerial risks or other qualitative risks, then the limit of the guarantee should be limited to the extent of the risk the bank is identifying.

The suggested formula to quantify a qualitative risk is: total bank financing (e.g., $200,000) X (times) risk percentage factor as outlined and agreed upon by the commercial banker (e.g., 40%) = amount of guarantee to be held (e.g., %200,000 @ 40% = $80,000).

If the banker indicates that the guarantee requirement is to offset multi risks identified, then you can still use the above formulas for each risk identified and add the total to calculate the total amount of guarantee required, up to the amount of company's bank borrowings.

The action plan

You have just negotiated the best possible amount of guarantee. What should your action plan look like? The purpose of an action plan is to ensure that the risks identified by the bank are eliminated over a period of time to allow for the smooth release of a guarantee(s).

Recommended guidelines: * Document the reasons for the commercial banker's need of a guarantee.

The benefit: To keep reminding you of what needs to happen before the guarantee can be eliminated.

* Diarize and obtain an agreement as to how the guarantee requirement will be reviewed by all parties. A review should be performed at least quarterly by you and at least annually by you and the bank.

The benefit: This will allow time for you and the banker to gauge improvements to finances and check the status of guarantee needs. It also shows the banker that your intention is to eliminate this contingent liability to the guarantor, which is likely to be you.

* Try the gauge approach. Establish a specific review of your financial gauges, including the ratios that the bank is looking at, and test monthly to check for improvements.

The benefit: It keeps you abreast of the financial trends of your company. When you see that the company's results are positive and within the bank's parameters, this may be a good time to start discussions with the bank about eliminating or significantly reducing these guarantees.

* After your company has financially performed within the bank's parameters and no new risks issues have come up, your bank should be in a position to release the guarantee(s) held.

Remember: Good financial results, knowing your market position well, and effective negotiations will make it happen for you.

Sam Soliman (sam.soliman@bmo.com), CMA, is the regional manager, Independent Business at the Bank of Montreal

Author's Note: Opinions of this article are solely the opinions of the writer and not necessarily those of the Bank of Montreal.

Follow these three basic rules when negotiating supporting guarantee requirements:

1. Know the specific risks the bank wants to mitigate by requesting a guarantee.

2. The guarantee should be limited to an amount that the bank can exercise their rights to. The limit of the guarantee should not exceed the total amount of the company's borrowings.

3. Know how to negotiate with your banker. A large part of deciding the amount of guarantee required is determined through effective negotiations. Be ready!

A guarantee may be a necessary step in obtaining conventional financing by your traditional commercial banker, but follow these guidelines to minimize your personal risk:

1. Know the specific reason(s) for providing supporting guarantee.

2. Limit the guarantee to an amount.

3. Use the different ratio calculation examples to your advantage in negotiating with your banker.

4. Keep on top of your risks until they have been mitigated. It is not only good for the bank, but it is also good business!

5. Review your company's financial and other improvements with your commercial banker at Least annually so that you can eventually eliminate your guarantee(s).

6. Once your commercial account manager has agreed to the release of the guarantee(s), get it in writing.
COPYRIGHT 2000 Society of Management Accountants of Canada
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Copyright 2000 Gale, Cengage Learning. All rights reserved.

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Author:Soliman, Sam
Publication:CMA Management
Geographic Code:1CANA
Date:Oct 1, 2000
Words:1967
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