Part 6 of 10 in our series on the real estate pain points that are costing small and mid-sized businesses money

A business owner signs a lease for office for office or industrial space. The lease is in the company’s name. The rent is paid by the company. The space is used by the company. But buried in the lease document is a provision that can change the financial risk dramatically: the personal guarantee.

A personal guarantee, often referred by landlords as “Enhanced Credit” means that if the business is unable to meet its lease obligations, the landlord may be able to pursue the business owner personally for some or all of the unpaid amounts.

For an owner who has spent years separating personal and business finances, that can create a significant—and sometimes unexpected—exposure.

Why Landlords Ask for Personal Guarantees

From a landlord’s perspective, a lease is a long-term financial commitment.

If a tenant is a relatively new business, has limited assets, inconsistent profitability, or does not have a long operating history, the landlord may be concerned that the company itself does not provide enough financial security to support a five-, seven-, or ten-year lease obligation.

A personal guarantee gives the landlord another source of repayment if the tenant defaults. Think of the landlord as a bank…. before it gives a borrower a loan, it looks to the borrower for some form of collateral as security in case the borrower cannot pay back the loan in the future. For startups and smaller privately held businesses, landlords may initially present the founders of investors a personal guarantee as a standard requirement.

The important point is this:

Standard does not necessarily mean non-negotiable!

The Risk Can Be Larger Than Owners Realize

Consider a company signing a five-year lease at $8,000 per month. Additionally, the landlord may provide its tenant with money for “tenant improvements” to the space, and it may be paying its listing broker a commission for the lease.

That represents $480,000 in base rent before considering operating expenses, taxes, insurance, utilities, or other lease obligations. The landlord may have provided the new tenant with a $100K in tenant improvement funds (a conservative $).

In the example above, if the startup defaults midway through its lease, the potential exposure can be substantial if an unlimited personal guarantee was included in the lease. Midway through the lease term (defaulting at 30 months through a 5-year term) could mean a personal liability of $240K in rent, $100K in tenant improvements, and roughly $19K in broker commissions…. a total of nearly $360,000 and in some cases more.

The founders and investors, let’s call them the tenant’s stakeholders, may have assumed the risk was limited to the company, but the personal guarantee transferred the lease liability to them personally.

Depending on how the guarantee is written, the landlord could potentially seek payment from the guarantor for rent, damages, legal fees, restoration costs, and other obligations under the lease.

That is why a personal guarantee should not be treated as routine boilerplate. It’s an economic and business term of the transaction, which risk needs to be assessed by the company stakeholders.

The Guarantee Itself Can Often Be Negotiated

A landlord may insist on some form of guarantee while still being willing to modify the amount or duration of the obligation.

Several structures are commonly negotiated.

1. A Burn-Off Provision

A guarantee can expire after the tenant demonstrates a history of reliable performance.

For example, an owner might provide a personal guarantee for the first 24 or 36 months of a lease, after which the guarantee terminates if the tenant has consistently paid rent and has not been in default. This often is the point when the landlord has covered its cash outlay of tenant improvements and leasing commissions it paid at the frontend of the lease

The landlord receives additional protection during the period it considers most risky, while the owner avoids remaining personally exposed throughout the entire lease term.

2. A Cap on Liability

Instead of guaranteeing the entire remaining lease obligation, the owner may negotiate a fixed maximum amount.

For example, the guarantee might be limited to six or twelve months of rent.  In our example above, the tenant’s stakeholders may only be liable for a fixed amount, such as the unpaid rent only.

This gives the landlord additional financial protection while establishing a defined limit on the tenant’s stakeholders personal exposure.

3. A Rolling Guarantee

Another approach limits liability to a specific number of months following a default.

For example, the guarantor may be responsible for twelve months of rent rather than the entire remaining term of the lease. Again, in or case above, even though there is 30-months left of the lease term, the tenant’s stakeholders would be responsible for 12-months of rent.

As the lease progresses, the owner’s potential exposure effectively declines.

4. A Partial Guarantee

The guarantee can also be limited to certain lease obligations rather than the entire agreement.

A landlord might agree that the owner guarantees only cash allowances such as tenant improvements and leasing commissions, for example, rather than every possible cost or obligation contained in the lease.

5. A Guarantee Tied to Financial Performance

In some transactions, the guarantee can terminate once the business reaches certain financial benchmarks or provides evidence of improved financial strength.

This can be particularly useful for newer companies that expect their balance sheet to strengthen during the lease term.

6. Other financial instruments

Although less common, through negotiation, a landlord may agree to not require a Personal guarantee, but another instrument that could provide the landlord some level of security for its investment putting the tenant into office space.  A bank Letter of Credit is such an instrument.

A Letter of Credit, however, has its setbacks. It would require the tenant to maintains a certain balance in its bank account(s), which the landlord can draw upon in case of default.

The Letter of Credit can be useful, however, may not apply to many small or startup businesses that cannot maintain enough cash in an account to meet the landlord’s requirements. But like Personal Guarantees, keep in mind any security instrument can be negotiated.

The important point here is: The landlord wants rent paying tenants; therefore, they will usually be flexible in finding a compromise that will meet both the tenant’s and landlord’s needs.

Leverage Matters

The ability to negotiate a personal guarantee depends heavily on the tenant’s circumstances and the market.

A landlord may have more leverage if:

• The business is newly formed.
• The company has limited financial history.
• The tenant is heavily dependent on a small number of customers.
• The space requires substantial landlord-funded improvements.
• The property has strong demand and multiple prospective tenants.

The tenant may have more negotiating leverage if:

• The company has strong financial statements.
• The business has operated successfully for many years.
• The tenant is investing significant money into the premises.
• The landlord has been carrying the space vacant.
• The tenant has multiple viable location alternatives.
• The tenant is renewing its lease after years of consistent payment history or can document a payment history from a prior location.

Like most lease terms, the outcome depends on the negotiating position of both parties. At CARMEN, we recognize this can be the case with many office or industrial lease agreements, therefore, we try to help position our clients to have the most leverage in the lease negotiations.

The Best Time to Address the Guarantee Is Early

One of the biggest mistakes business owners make is focusing on the rental rate during the early stages of negotiations while leaving the personal guarantee for the lease-document stage. By then, much of the business deal may already be considered settled.

The better approach is to address the guarantee during the letter-of-intent stage when all economic and business terms are on the table. If the landlord expects a personal guarantee, the parties should discuss:

• Whether a guarantee is required at all.
• Who must provide it.
• How long it remains in effect.
• Whether the amount is capped.
• Whether it reduces over time.
• What conditions allow it to terminate.

Resolving these issues early can prevent a major disagreement after attorneys begin drafting lease documents.

One Signature Can Change the Risk Profile

For many business owners, the company’s lease is one of its largest long-term financial commitments.

A personal guarantee can turn that corporate obligation into a personal one.

That does not mean every personal guarantee is unreasonable. In some situations, a landlord may legitimately require additional security before committing significant capital or entering into a long-term lease with a smaller company.

But business owners should understand exactly what they are agreeing to. The question should not simply be:

“Is a personal guarantee required?”

It should also be:

“How much am I guaranteeing, for how long, and can that exposure be reduced?”

Those questions can materially change the economics—and the personal risk—of a commercial lease.

Up Next — Part 7 of 10: Another commonly overlooked commercial real estate issue that can cost small and mid-sized businesses money: Tenant Improve