Common among most financing arrangements for small and medium sized businesses is some form of personal guarantee on the part of the owner. If your customer is the U.S. Government, the form of that guarantee is important. For government contractors, guarantees that may sound benign can have unintended consequences.
The two most common types of guarantees are (1) personal guarantees, and (2) validity guarantees.
Most business owners are familiar with a personal guarantee. It is simply a promise to repay a loan if the company cannot repay it. For a commercial bank, requiring a personal guarantee is not unreasonable given the regulatory scrutiny banks are presently under. For an unregulated finance company, a personal guarantee can be appropriate if the loan is based on cash flow and not pledged assets, such as receivables. If the loan is asset-based, and provided by a finance company, then the personal guarantee is often, but not always, required.
Less well-known is the validity guarantee, which is almost always related to asset-based financing provided by finance companies. This is not a promise to repay the loan but rather a promise that the assets being financed – most often receivables – are valid.
In a commercial transaction, a validity guarantee may be preferable to a personal guarantee. It allows the owner to personally avoid the credit risk of its customer. However, a government contractor should avoid a validity guarantee at all costs.
Here is the logic:
In the commercial sector a receivable may not be paid because a company’s customer may go bankrupt. Because bankruptcy risk of the U.S. Government is nonexistent, the only reason the U.S. Government will not pay a receivable is if it is not valid. If an owner has guaranteed that a receivable is valid, and it does not get paid, the owner has technically made a fraudulent representation. And that can be far worse than having to pay back a loan.
Try to avoid a guarantee of any type. In a nonbank, asset-based financing it ought not to be necessary. But, if you find yourself having to provide one, opt for the personal guarantee and shun the validity guarantee.
Carlos Salazar is Managing Director of Blue Insight Consulting, LLC. In this role, Mr. Salazar leverages 14 years of progressive experience leading and managing fast growth businesses and high performance teams in the government contracting market space. He can be reached at firstname.lastname@example.org.