It is crucial to understand the difference between a personal guarantee and validity guarantee. This is because it is a key to understanding your invoice factoring paperwork.
By law, a guarantee is 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. This ensures that it will be able to recover the upfront payment they have provided you in case your customer default to cover the invoice.
You can identify two types of guarantee, the personal and validity.
What is a Personal Guarantee?
A personal guarantee is defined as an individual’s legal promise to repay charges to 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 recovery of their money. Therefore, a personal guarantee induces that as a business, you are personally liable. This usually occurs when there is a shortfall on the facility which is generally limited to an agreed amount. However, you will still be liable for any shortfall no matter what the reason.
Use of the personal guarantee is not only by traditional lenders. Factoring companies who wish to claim personal assets not related to the business itself use this. The reason for this is to send payment back in the case of a defaulted debt. This guarantee put your personal assets as the first source to recover the deficit before taking any action against your customers.
Many believe this type of guarantee to be extreme since you have to be willing to assume the risk personally. Therefore, it is crucial to reflect if you can tighten your own assets to your business. This is especially true 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. Additionally, they can 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. It is, instead of a promise of financing the assets. 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. However, it doesn’t contain 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 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. This is because it allows you, as an owner, to personally avoid the credit risk.
Under a validity guarantee, specific 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. After such notification, you then need to 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. In doing so, not only will it simplify their payment process 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. Protection from any risk for both your company and you as a business owner when your customers default on their accounts.