Why Are Personal Guarantees Necessary When Leasing?

During the last few months I have had several conversations with a number of potential customers about why they sometimes need to provide a personal guarantee for an equipment lease.

Before I detail exactly what a personal guarantee is and why financial institutions will ask for this type of security, I think it is important to look at the psyche of the typical owner/operator in the manufacturing industry.

Brand Awareness

My professional career exclusively in the machine tool industry has led me to make numerous contacts in the U.S., Europe, and the Far East. When dealing in these areas, I’m often asked why Canadians are so price-conscious. In most other countries, and in particular the U.S. and Japan, the typical buyer is brand-loyal and will continue to purchase their favourite brand even if they have to pay a premium.

When I was selling equipment, I never found such brand loyalty to be consistent in Canada.

Why is this the case? I think it boils down to differences in taxation and culture. If, for example, you compare tax rates in the U.S. to ours, you will have no doubt that Canadians are taxed much more heavily than our neighbours to the south.

In terms of culture, if you look at truly successful Canadian manufacturing companies, you will see that a common thread is they typically all started out working as an operator or apprentice. Many started with a very strong engineering background, honed on the shop floor while working for someone else, and eventually started their own business in a competitive industry where a few cents per part could mean the difference between winning or losing hundreds of thousands or even millions of dollars.

Now when you combine those facts with the nature of business owners who have a strong technical background and inherent knowledge of how to make complicated parts from a time, labour, and material perspective, you get people who truly understand value.

It is easy to understand why they would be very sensitive to pricing, and the thought of borrowing money and paying even a penny in interest may not be too palatable.

Financial History

What this leads to is successful companies that run on their own cash flow and do very little borrowing beyond perhaps an operating line with their bank.

This can become an issue when a new contract is won and an expensive piece of equipment is required, but the manufacturer has very little commercial borrowing history on record.

Harman Aujla, senior commercial analyst at Blue Chip Leasing, put it best when he said, “A typical company normally has four stages: startup, growth, maturity, and decline, and a potential borrower should expect any lending institution will require a personal guarantee in at least three of those stages.”

It is when the manufacturer is at the maturity stage that most owners struggle to understand why their guarantee is required because, in reality, the company has been profitable for many years.

Many potential borrowers show up at my door who are well-established, been in business for a decade or more, and who are running very successful operations but do not have any lending history. While they always have some sort of banking relationship, normally predicated on the personal credit of the owner of the business, this is not particularly helpful when a company is being evaluated for a commercial lease. It can be complicated even further when the financial statements have been set up to minimize taxes.

Personal Guarantee Needed

Most financial institutions, particularly ones that work within the manufacturing industry, regularly see companies that are extremely successful and have a significant amount of assets on their floor, owned free and clear. But their success does not translate on paper and they find ways to work around the situation. The first condition of a leasing approval in this situation will include personal guarantee of the owner or majority shareholder.

This guarantee is the owner’s legal promise that if the business becomes unable to repay its debt obligations, the individual guarantor is personally responsible.

This does not mean, however, that in the event of a default, the lending institution can take other commercial assets like existing equipment or personal assets such as property, unless they have been specifically pledged. It only means that the individual is personally liable for repayment.

From a lender’s perspective having the owner’s personal guarantee typically adds security because the lender knows the owner is now fully engaged to do everything possible to ensure the company’s success and make good on all debt commitments.

There is no doubt that securing financing for new equipment is something that every company will need to engage in at some point. And, even though most individuals already have a lender in place who they are comfortable with, it is still imperative to understand the financial security that is required and, most importantly, why it is needed.