Personal Guaranties and Service Contracts – A thorny legal issue
by Peter Smith
February 20, 2012
in Articles, Benefit Corporation, Contract, Dispute Resolution, Guaranty, Personal Guaranty, Personal Liability, Social Enterprise, Social Entrepreneur, social entrepreneurship
Many founders of small companies and social enterprises will be asked to Guaranty service contracts or engagement agreements with consultants or contractors. This should raise some key questions before any founder or small business owner puts themselves, and their assets, on the line for these relationships.
The concept of the personal guaranty is not a new one. Traditionally personal guaranties tend to be confined to banks and other lenders dealing with businesses who do not have the assets or revenue history to collateralize a loan or line of credit. The idea being is that by having a owner/founder put their personal assets behind the businesses’ line of credit or loan, the bank can be secured in knowing that they will be repaid the funds they are loaning.
Increasingly, however, business owners or founders are being asked to shoulder a broader array of liabilities when it comes to personal guaranties. Specifically – consultants and/or professional service providers may ask a business or social enterprise founder to provide a guaranty for their engagement or service contract. Ostensibly the concern on the part of the consultant in these instances is similar to that of a traditional lender – they want to be secure in knowing that they will be paid (or repaid in the bank’s case) for the value they provide through their services. Unlike a bank, however, the value of the services received from a third party contractor or consultant is by no means fixed or absolute. A bank loan of $50,000 can be easily quantified. The company receives $50,000 to immediately put to use in growing the business. That quantification cannot be as easily measured when it comes to consultants. If you have hired an individual or company to (1)help raise funds or investment capital; (2) put together offering material for an anticipated financing; (3) provide a valuation for your company; (4) assist in risk assessment; (5) help generate revenue for your business through marketing or business development; or (6) provide any other related service aimed at growing your business, then the value added to your company becomes a question of results.
Accordingly, in circumstances where you are faced with a consultant or contractor wanting you to provide a personal guaranty on a service contract or engagement agreement – you need to ask a few questions first:
1. How much are you planning on billing?
If a consultant asks you for a personal guaranty, it means they intend to be doing a fair amount of work on your behalf. A significant enough amount of work that they can’t afford not to have the debt secured by a guaranty. Therefore, if you are anticipating someone doing work on your company’s behalf, but do not think that it should take hundreds of hours or involve running up a huge bill, you need to ask for some assurance that won’t happen. This needs to be in writing, and part of the engagement agreement and any guaranty. Restricting the scope of work and making sure it remains below a certain threshold will protect your company, as well as yourself, from being subjected to an unexpected liability. It will also give you a little insight into the motivation of the consultant, who should not have a problem with your seeking such protection (indeed- any consultant seeking to increase stability in your enterprise should applaud such a move). Any consultant who bristles at the notion that your company (and you by way of any guaranty) should be protected from a large and unexpected invoice, secured or otherwise, may not have the right motivation behind the relationship.
2. What should the limit of personal liability be?
If you are faced with a situation where you really do need a consultant’s services, and that consultant is unwilling to move forward without a guaranty, then it would be a very good idea to cap the amount of the guaranty. Again – this could be tied to scope of work. If it is completely necessary to provide the guaranty before moving forward with a consultant, then it would seem equally reasonable and necessary for the guarantor to obtain some security about what it is that they are guaranteeing. Remember, this is not the same situation as with a bank loan or line of credit, where the amount being secured through the guaranty (generally amount borrowed plus interest and fees) can be relatively easily ascertained. Giving a consultant the proverbial blank check in terms of an hourly engagement agreement or services contract could open up a company, and anyone providing a guaranty, to significant risk.
Instead, come up with a reasonable cap on personal liability that will secure the consultant, and provide assurance to the guarantor that they won’t be faced with an unreasonable liability.
Ultimately, it is important to remember that in situations where a small company is bringing on a consultant or contractor to provide assistance, the rationale behind the move is that the party being brought on board is a value add to the company. That is to say that the consultant will help reduce the company’s liabilities – not add to them. Increase the company’s revenue stream, not deplete it. In most instances, this will be a mutual goal of the parties, who are seeking to forge a longstanding relationship.
Increasingly, however, and perhaps this has been a byproduct of the tough economy, founders are being asked to shoulder more and more personal liability when it comes to their operations. This is difficult, however, as most business owners and social entrepreneurs already have their personal resources sunk into their business as it is. They cannot afford to be leveraging those assets any further through personal guaranties and for that reason, it is generally a bad idea to guaranty any obligation unless it is absolutely imperative to move the business forward.
If it is entirely necessary, however, and if you are faced with a consultant or contractor who seeks a personal guaranty around their engagement, make sure you ask the tough questions and get restrictive language, in writing, into the engagement agreement or contract being executed. Doing so will set the expectations of both parties, and protect personal assets from any wayward consultant who abuses the power of their engagement.
If you have any questions about this article, or wish to discuss the contents of this article further, please feel free to contact me at any time at Eric@apexlg.com. For more information about the Apex Law Group, LLP, visit our website at www.apexlg.com.
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