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February 1, 2022 | By Patrick T. McCloskey
First-time founders pivoting from the Great Resignation should be aware of the significance of signing a personal guaranty.
As background, founders typically operate through a business entity to protect themselves from personal liability (any founder who does not should read my prior blog post on this topic). While this protection is not bullet-proof, piercing the corporate veil is a rare exception to the general rule that corporate shareholders and limited liability company (LLC) members are not liable for the obligations of the business entity.1 Sophisticated creditors, such as bank lenders and commercial landlords, will often seek a personal guaranty from the founder to protect against the risk that the entity’s assets are insufficient to pay the applicable obligation(s).
While first-time founders may understand that a personal guaranty will put their personal assets at risk, they may not fully appreciate the potential consequences of certain provisions that creditors typically insert into these documents.
Guaranties must be in writing to be enforceable under New York law.2 Since guaranties are almost always drafted by or on behalf of the lender or landlord, they naturally include provisions that will protect the creditor, including express waivers of defenses that might otherwise be available to the guarantor. Since the execution of a personal guaranty is often presented to a founder as a take or leave it proposition, the natural inclination for an ambitious, newly minted entrepreneur may be to just sign it and move on.
Founders should consult with an attorney to understand what they are being asked to sign up to. Here are some legal pitfalls to look out for and possible alternatives that may limit personal exposure.
Most personal guaranties contain express language that the instrument is a guarantee of payment, not a guaranty of collection. The legal translation of this phrase is that the creditor need not exhaust remedies against the primary obligor (i.e., the business entity) before seeking payment from the guarantor. This gives the creditor significant leverage with a founder if there is ever a dispute related to the primary obligation. In a sense, this language usually results in a double-whammy against the founder/guarantor. Not only can it put the founder front and center, but, as described below, the founder is further exposed as a result of the defense waivers that are typically included in a guaranty.
An “absolute and unconditional” guaranty, which typically includes specific express waivers, generally precludes the guarantor from asserting defenses that the primary obligor has against the creditor.3 As a result, this language and the related waivers essentially put the guarantor in a legal straightjacket with no ability to raise the substantive defenses that are available to the primary obligor, including the statute of limitations.4
From a practical standpoint, sophisticated creditors are unlikely to remove or modify the above referenced clauses from a personal guaranty. This does not, however, mean a founder should simply acquiesce. Aside from walking away from a deal, a founder can, as a compromise, attempt to negotiate limitations on their personal exposure.
One simple approach would be to propose a specified dollar limit on the personal guaranty. In addition, a founder can propose to limit the duration of the personal guaranty.
In the context of a lease, a founder could propose a so-called “good guy guarantee,” which provides a potential escape hatch from long-term lease obligations if the business entity is willing to terminate early and exit the premises.
Another possible alternative would be to propose a nonrecourse guaranty to limit exposure to specified collateral owned by the guarantor. This will give the creditor a security interest in the specified collateral,5 but there would be no recourse to the guarantor’s other assets. As an example, a founder could offer to pledge the equity in the business or, if that is rejected, certain specified personal assets the founder is comfortable putting at risk.
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This post is for general informational purposes only and does not constitute legal advice. No one should rely on the information in this blog post without seeking appropriate legal, accounting, tax or other appropriate advice from an attorney, accountant or other professional properly licensed in the applicable jurisdiction(s).
1There are statutory and common law exceptions to this general rule.
2See New York General Obligations Law § 5-701(a)(2)
3See Cooperative BA v. Navarro, 25 NY3d 485, 493 (2015) (“Guaranties that contain language obligating the guarantor to payment without recourse to any defenses or counterclaims, i.e., guaranties that are ‘absolute and unconditional,’ have been consistently upheld by New York courts”) (citations omitted)
4Id. at 493, citing Walcutt v. Clevite Corp., 13 NY2d 48, 55 (1963) (“guarantor may not raise as counterclaims or defenses those claims belonging to the principal obligor”); American Trading Co. v. Fish, 42 NY2d 20, 26 (1977) (“guarantor may not raise as a defense the expiration of the statute of limitations against the primary obligor”).
5Aside from the general importance of seeking advice of counsel on a personal guaranty, it is critical that a founder seek advice of counsel before signing a personal guaranty that will be secured by the guarantor’s assets.
