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By Jeff Guldner
Often, small business owners will ask why lenders require them to sign a personal guaranty, especially when the lender also requires the business to pledge all or substantially all of its assets as collateral. The reasons are somewhat inter-twined, but the short answer is that it is a function of risk and the fact that most small businesses are also closely held and controlled.
As a rule, small businesses are riskier ventures than large businesses. In fact, the failure rate and default rate of a business increases as its size decreases. Said another way, size does matter. This is one reason why the lender will require a backup or secondary source of repayment in the form of a PG.
Another reason is that the small business is often closely held by one person, a family or several partners and is therefore simply an extension of the owner(s) and their lifestyle. The owner has absolute control of the business, being able to affect all decisions that impact the success or failure of the company, including strategic direction, policy making, management, capital structure, asset sales, liquidation and owner’s compensation. A PG is a show of confidence by the owner that the decisions being made are with an eye toward being sound financially and with the interests of creditors also in mind.
Finally, when a small business is no longer viable, the lender and other creditors are more likely to be repaid if the owner remains actively engaged in the orderly wind down or liquidation of the business. The owner can maximize asset sale or liquidation values as opposed to “throwing the keys to the bank.” The lending community often refers to this phenomenon as “aligning the interests of the owner with those of the lender.”
A logical follow up question is what needs to happen to negate the need for a PG in a small, closely held business. The short answer is that it probably won’t happen as long as the business remains small and closely held, given the reasons above. However, at some point lenders will not require a PG and factors influencing this decision are not only size and ownership structure but also the financial wherewithal of the company, collateral coverage, and depth and breadth of the management team. While not a true substitute for a PG, lenders may rely on financial and other covenants, as well as, asset based lending arrangements to control their lending risk. It is generally accepted in the marketplace that lenders will require PG’s on all closely held businesses and that getting a lender to move off this requirement becomes less likely the smaller and more closely held the company is.
To summarize, PG’s will be required from the controlling owner(s) in most all cases where you have a small, closely held business for the simple reasons that smaller businesses are generally riskier than larger ones and that the small business is considered an extension of the individual controlling it and therefore that person should be financially responsible for it. In the event the business suffers financial distress or fails, the continued involvement of the controlling owner in facilitating an orderly wind down or liquidation of the business generally results in a more favorable outcome for the creditors.
*A personal guarantee is an unconditional promise to pay, made by the individual owner, in the event of default or the inability to pay by the business.
Jeff Guldner has over 30 years of experience in credit risk assessment and management for major lending institutions. Guldner is the Chief Credit Officer for Ftrans. Ftrans combines accounts receivable management with affordable access to funding – providing small and medium-sized businesses the cash they need to take advantage of market opportunities and grow.
Consider this:
Surviving in today’s economy is dependent upon one thing: getting paid. Many small to mid-sized B2B companies are failing not because of a decline in sales, but because they do not have the cash-on-hand to survive if their customers fail to pay. In this economic climate, business owners have to plan for the worst in terms of their own finances, as well as take their customers’ financial situation into consideration.
It generally takes a small business 56 days to get paid by its customers. For a company selling $20,000/week, that’s eight weeks of sales outstanding, which equals $160,000 in untouchable assets. What would the difference be for a company of this size if, instead of risking that amount, it could have guaranteed access to 90% of that capital within 3-4 days rather than 7-8 weeks?
The economic crisis has affected almost every sector of the US economy but there are a few steps B2B companies can take to protect their businesses from losing money this year. Business owners should take into consideration the credit worthiness of their customers before making sales and have a backup plan in place to prevent a loss in revenue from buyer bankruptcy. In today’s market, it’s important to understand the consequences of the business relationships keeping a company afloat and although it’s possible for companies to grow under these circumstances, having an added layer of protection certainly helps.
One increasingly popular way for SMBs to protect themselves from being subject to a customer’s failure to pay is by AR Outsourcing. Here’s some background on how AR outsourcing works and the implications it could have on the health of a company:
Know Who Your Customers Are
Business that use AR outsourcing should implement an underwriting and credit verification process before verifying invoices so that businesses immediately have a transparent look into the creditworthiness of their customers. As a business owner, having this insight helps you avoid selling to someone who might not pay on time – or at all.
A business’ credit management provider should also maintain an ongoing credit monitoring system with its customers to help establish a credit policy that includes trade credit limits and payment terms. Having an understanding with customers about the extent to which you will lend helps ensure a healthy business relationship and protects against unpaid invoices.
Put the Burden on Someone Else
Similar to a B2C company accepting a credit card for payment, AR outstourcing puts the invoicing burden on the credit provider. By working with financial institutions, the credit management vendor borrows against your AR, takes on the debt and provides you with the capital upfront. In some instances, businesses get paid in as few as four business days, which eliminates the hassle of slow paying customers while also increasing a business’ cash-on-hand.
Businesses Have More “Insurance”
By outsourcing AR, businesses are often guaranteed a certain percentage of each sale, thus providing “insurance” for their invoices. In addition, in the event that a customer does go bankrupt, the business is protected and will still get paid. For certain credits, credit insurance backs each sale for up to 90-100% of the amount of the sale made.
By: As founder of FTRANS, John B. Hayes brings over 30 years of experience in developing technology-based companies that help businesses manage their finances. John was also co-founder and president of the company that built Peachtree Software products, the first microcomputer accounting software. He recently published a book entitled, “Use the Credit Crisis to Grow Your B2B Business: A Proven Strategy for Enduring Competitive Advantage and Business Growth, Especially in Times of Crisis or Recession.”
Ftrans combines fast and affordable access to funding professional with receivables services – providing small and medium businesses the business line of credit they need to grow and take advantage of market opportunities. Liberating you from funding challenges and receivables hassles.
I spent some time at the large payroll processor ADP. A very successful company and a very successful public company. They had a significant focus on ‘earnings quality.’ Wikipedia defines Earnings quality as an assessment criterion for how “repeatable, controllable and bankable”[2] a firm’s earnings are.
Since I’ve been involved in the Commercial Finance business, I think of Accounts Receivable in much the same way – how reapeatable, controllable, and bankable is your AR? Every business owner or manager is justifyablely proud of his or her customers – they are the lifeblood of the business. But others, with less pride of ownership, take a more jaundiced view of business practices and their impact.
I’ve quoted in other articles this combination of two Norm Brodskyism’s: It’s only a sale if you get paid for it. That is the essence of quality Accounts Receivable: are you really going to get paid for the sale?
The current state of the state in best practices in Accounts Receivable says: bill correctly and accurately, set the terms to the actual due date, then enforce it …
These practices are key to ensure 1) that credit risk is minimized, 2) that time to payment is as predicted and 3) that dilution is minimized.
AR Dilution is how much you don’t get of what you thought your sales were. This AR dilution stuff includes short pays, discounts, returns, disputed deliveries, or damaged goods. It doesn’t really matter who is at fault in any of this, it just matters that you have AR dilution and didn’t get as much in actual cash for the sale as you originally hoped.
Often this shortfall is based on the quality of the Receivable.
We lend on Receivables. This requires us to develop an opinion of their quality and typically AR dilution. So, let’s take a tour of the Account Receivables in various industries to give you an idea of what I’m talking about.
Hopefully, this view of your business will enable you to better forecast cash and ultimately better run your business. Think about your business in terms of how you sell, contract, and bill; then, how you collect. And think about this key measure: be sure you know how much cash you really are going to get.
Dan Drechsel is CEO of Ftrans. Prior to joining Ftrans, Dan was General Manager of SAP’s Banking business in the Americas. Dan has alos served as President of Global Energy Decisions and was President and COO of S1 Corporation (Nasdaq: SONE), a leading provider of technology solutions for financial institutions and one of the key leaders in distribution channel innovation surrounding the growth of internet banking. Previous to that, Dan served in key executive roles with CheckFree, ADP and D&B.
Ftrans combines fast and affordable access to funding professional with receivables services – providing small and medium businesses the business line of credit they need to grow and take advantage of market opportunities. Liberating you from funding challenges and receivables hassles.
For months we have been scratching our heads. News story after news story would have us all believe that there is little demand for business lending. We just had a hard time believing that was true. Karen E. Klien’s interview with John Paglia in BusinessWeek had us nodding our heads instead. Full article.
Why Small Business Can’t Get Financing
Small companies are desperate for growth capital, but banks and investors remain cautious, says Pepperdine Private Capital Markets Project’s John Paglia.
Associate finance professor John Paglia is senior researcher for the Pepperdine Private Capital Markets Project, a twice-yearly survey of privately owned businesses and the lenders and investors who fund them. Its latest report shows that multiple efforts to shake loose capital over the past 18 months are not working, Paglia says, and Main Street continues to suffer. He spoke recently with Smart Answers columnist Karen E. Klein; edited excerpts of their conversation follow.
Excerpted…
Many bankers say they aren’t lending, at least in part, because demand for loans is down. But your survey seems to contradict that assertion.
Generally speaking, we found more demand for loans among business owners. And among the banks that responded to our survey, 72 percent indicated that the number of loan applications they received had increased during the last six months. So there’s demand for capital. Something’s not quite sitting right when we hear from the banks that there’s no demand.
What about loan approval rates?
The banks reported that they declined 72 percent of cash flow-based loans, 90 percent of real estate-based loans, and 46.7 percent of collateral-based loans. The quality of cash flow and earnings were cited as the top two reasons that loans were declined, followed by weakening industries and current debt loads.
But your survey shows that the creditworthiness of borrowers has been going up, despite the economy.
Yes. The majority—55 percent—of bankers said the credit quality of potential borrowers has increased in the past six months. That may reflect the fact that the banks are risk-averse, and companies know that they’re really ratcheting up their standards. Almost 39 percent said they had tightened up their loan agreements’ financial covenants.
What about your business? Could you use growth capital?
Sandra Chesnutt is a Marketing Director with Ftrans. Ftrans combines professional receivables services with fast and affordable access to funding – providing small and medium businesses the cash they need to grow and take advantage of market opportunities. Liberating you from funding challenges and receivables hassles.
Quotes from Ben Bernanke, Federal Reserve Chairman, regarding small business lending during his whistle stop tour of the U.S. economy, as reported by Business Week:
“Our collective challenge is to help ensure that creditworthy borrowers have access to credit so that, should they choose, they can expand their businesses or increase payrolls, helping our economy to recover,” Bernanke said at the event at the Chicago Fed’s Detroit branch.
…
Outstanding loans to small businesses have declined to about $660 billion in the first quarter of this year from almost $700 billion two years ago, Bernanke said. It’s “difficult to answer” how much of the drop comes from declining demand and how much from supply, he said.
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Bernanke said he would offer “a little bit of guarded optimism” on lending.
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“We’ve still got a long way to go but I’m hopeful that we’ll see improved conditions for credit going forward,” he said. “The Federal Reserve views this as being absolutely central to the recovery.”
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Bernanke said the central bank is training its bank examiners and giving them the “message that encouraging lending to small businesses that are well positioned to repay is positive, not negative, for the safety and soundness of our banking system.”
And they all lived happily ever after! But seriously, this raises a big question on my mind that could tell us if we are inching forward or not. What do you think?
Is the economy held back because banks won’t lend?
Or are banks unable to lend because small to medium sized businesses just really don’t need additional capital?
Full Business Week article:
