It is crucial to understand the difference between a personal guarantee and validity guarantee as it is a key to understanding your invoice factoring paperwork. By law, a guarantee is defined as an undertaking to answer for the payment or performance of another person’s debt or obligation in the event of a default by the person primarily responsible for it. Therefore, a guarantee is a promise from your business to your factoring company ensuring it will be able to recover the upfront payment they have provided you in case your customer default to cover the invoice. Two types can be identified: personal and validity.
What is a Personal Guarantee?
A personal guarantee is defined as an individual’s legal promise to repay charges to a business, meaning that the individual provides a personal guarantee that in case the debt is left unpaid, the individual guarantor takes personally the responsibility. This guarantee usually provides an extra level of protection to lenders who want to ensure their money will be recovered. Therefore, a personal guarantee induces that as a business, you are personally liable if there is a shortfall on the facility which is usually limited to an agreed amount but you will still be liable for any shortfall no matter what the reason. The personal guarantee is not only used by traditional lenders but also factoring companies who wish to claim personal assets not related to the business itself, in order to be paid back in the case of a defaulted debt. This guarantee put your personal assets as the first source to recover the debt before any action is taken against your customers. This type of guarantee is believed to be extreme as you have to be willing to personally assume the risk. Therefore, it is crucial to reflect if you are able to tighten your own assets to your business when considering to sign a personal guarantee. Discussing this matter with your factoring company is then vital as only your factor can release you from this guarantee and offer you a different alternative option.
What is a Validity Guarantee?
On the contrary, a validity guarantee is not a promise to repay the loan but rather a promise that the assets being financed, typically receivables, are valid. A validity guarantee is a special kind of guarantee used in Invoice Factoring & PO Funding when a small business is owned by many individuals or a corporation. It is a guarantee that states the information submitted on a borrowing base certificate or factored invoices is true and accurate. It holds the signer liable in the case of fraud or misrepresentation but doesn’t hold the signer liable for credit loss if a non-recourse facility. Thus, most invoice factoring companies prefer to use this less extreme type of guarantee which ensures instead the state of your accounts receivable, their validity, exclusivity, and collection. In a commercial transaction, a validity guarantee may be preferable to a personal guarantee as it allows you, as an owner, to personally avoid the credit risk.
Under a validity guarantee, certain requirements need to respect:
- Any misdirected payments must be forwarded to the factoring company. For instance, if your customer pays you instead of your factor, you need to notify you factor and send him the owed money.
- A provision granting the factor the priority and the rights to allowed money in the unfortunate case that your business files for bankruptcy.
In exchange, your factoring company will typically agree to provide all needed invoice documentation to your customers not only to simplify their payment facilitate their payment but also to fulfill any other essential requirements necessary to continue to do so. This way, your factoring company assumes the risk regarding a potential non-payment of the purchased invoices. Both your company and you as a business owner, are protected from being at risk when your customers default on their accounts.