Friday, 22 April 2016

Divorce: How are Personal Guarantees on Business Debt Handled ?

It is a common situation where one spouse owns and operates a privately-held business and the non-owner spouse agrees to guarantee some portion of the business debt.

This blog post will examine how personal guarantees for business debt are dealt with in the context of a divorce.

The use of a simple example can illustrate some of the issues that are at play:

Suppose that a couple is going through a divorce. Assume the husband (Mr. John Smith) owns and operates a business through a privately-held company, of which he is 100% shareholder. Let's pretend this corporation has $100,000 in loans from the bank and that Ms. Nancy Smith has personally guaranteed the full $100,000. Nancy is NOT a shareholder of the company.

The question is, how is the personal guarantee from Nancy dealt with now that the couple are divorcing? Is it a liability for Nancy?

Possibly. It is a contingent liability. In other words, it is a liability that may come to fruition.... but may not.

Therefore, it is important to consider the following:

  •  How likely is it that the business will default on the loan and Nancy's personal guarantee will be called upon by the bank?
  • How much will Nancy be likely to pay? This is a function of the amount that Nancy has personally guaranteed but also the other security the bank holds on the debt which may mitigate some or all of her exposure.  If the bank has tangible assets in the company as security for the loan, then this could impact the amount of Nancy's overall exposure.
  • If it is expected that the personal guarantee will be called upon... then when is it expected to be paid.... Is it imminently? The near future? Perhaps the distant future?? If it is not expected to be immediate then the net present value of the expected payment must be computed.
There are no 'set in stone' rules on valuing such a contingent liability but a skilled Chartered Business Valuator will always go back to first principles, which are: estimate the likelihood of a payment, the amount of money expected to be paid, and then compute net present value to account for risk and the time value of money.

Important to remember: personal guarantees can also affect the business value, which impacts the net family property calculation in a divorce.

The other issue to consider is that the presence of the personal guarantee from Nancy may also impact the overall valuation of John's business. This would certainly have ramifications for John's net family property calculation if it reflects in a lower business valuation for his company shares.

Consider... because of Nancy's personal guarantee, the business's cost of debt is lower than it would have otherwise been. The cost of debt for the business is artificially low due to Nancy's personal guarantee. The cost of debt does NOT merely reflect the business's ability to borrow - the business's cost of debt is being 'subsidized' by the personal guarantee Nancy has agreed to. In other words, if a buyer came along to buy the business, they would have a higher cost of debt since they would not have the benefit of Nancy's personal guarantee. Therefore, in a notional business valuation, the overall cost of capital would go up (due to higher cost of debt that a buyer would be expected to pay) which would result in a lower business valuation.

For assistance with business valuation issues please contact Keystone Business Valuations. We are located in Burlington and serve the GTA and southern Ontario.

Steve Skrlac, MBA, CFA, CBV

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