Guaranties, Security Deposits and Credit Support

An investor buying your building is buying a long series of rent payments. The building is collateral, but the investor's return depends on the tenant paying for the whole term. So one of the first questions in any offer is which legal entity will sign the lease and what stands behind it.

For many privately held companies the answer is not simple. The operating business may sit in one entity, the real estate in another, valuable equipment or intellectual property in a third, and a holding company above them all. If the proposed tenant is an entity with few assets, the investor will ask for something more. What you offer, and what you decline to offer, moves the price and shapes your risk for years.

• Tenant entity selection: putting the lease in the name of the main operating company, or the parent, rather than a thinly capitalized affiliate. This is the simplest form of credit support and often the one investors value most.
• Corporate or parent guaranty: another company in your group promises to pay and perform if the tenant does not.
• Cross-guaranties from affiliates: used when revenue and assets are spread across several operating entities.
• Personal guaranty: one or more owners promise to pay from their personal assets.
• Cash security deposit: money held by the landlord and applied if the tenant defaults.
• Letter of credit: a bank's commitment to pay the landlord on demand, issued for the tenant's account. It usually ties up borrowing capacity or cash with the issuing bank.

These can be combined. A common negotiation is to substitute one for another: for example, a larger deposit or a letter of credit in place of a personal guaranty, or a parent guaranty in place of both.

Investors pay more for rent they regard as safer. When the entity behind the lease is stronger, the investor will generally accept a lower return, which means a higher purchase price for the same rent. When the credit is weaker or harder to evaluate, the investor asks for a higher return, a lower price, more security, or all three.

This creates a real trade. You may be offered two versions of the same deal: one price with the operating subsidiary alone on the lease, and a better one with the parent company's guaranty. Neither is automatically right. The better price is cash at closing. The guaranty is a claim on the rest of your group for the life of the lease. Ask each bidder to price the alternatives explicitly so you can see what the support is worth to them, instead of guessing.

Do not volunteer credit support in the first round. Find out what each investor requires and what it would pay for more, then decide.

Owners of closely held businesses are often asked to guarantee the leaseback personally, particularly when the company's financial statements are unaudited or its history is short. Before agreeing, consider what the guaranty covers. A full guaranty of a long lease covers not only rent but taxes, insurance, maintenance, restoration and the landlord's costs of enforcing the lease, for the entire remaining term.

Consider also that the lease will probably outlast your ownership. If you sell the company or retire, a personal guaranty does not end unless the document says it does. If a personal guaranty cannot be avoided, there are well-established ways to limit it.

• A cap: liability limited to a fixed amount or to a stated number of months of rent and charges.
• A burn-off: the guaranty reduces or ends after a period of on-time payment, or once the company meets a financial test.
• A good-guy structure: the guarantor is liable only for obligations that accrue up to the date the tenant surrenders the building in the required condition. Availability varies by market and investor.
• A release on sale: the guaranty ends when the company is sold to a buyer that meets agreed standards or delivers a replacement guaranty.
• Several, not joint, liability: where there are multiple owners, each is responsible only for a share.

A guaranty is a separate contract with its own legal consequences. Have your attorney review it, and tell your CPA and your bank before you sign, since your loan agreements may restrict or require disclosure of guaranties.

A security deposit or letter of credit is a defined, limited form of support, which is why many owners prefer it to a guaranty. The cost is liquidity. Cash posted as a deposit is cash that is not working in the business, which cuts against the purpose of the sale-leaseback.

• ✓Can the amount step down on a schedule if rent is paid on time?
• ✓Can it be reduced or returned once the company reaches a stated financial measure?
• ✓May a letter of credit be substituted for cash, or the reverse, at your election?
• ✓When may the landlord draw, and must it give notice first?
• ✓If the landlord draws, are you required to restore the full amount, and how quickly?
• ✓If the building is sold, is the deposit or letter of credit transferred to the new owner and the old owner's responsibility for it documented?
• ✓Is cash held in a separate account, and who receives any interest?

Credit support is not only about security at signing. Investors usually require ongoing visibility into the tenant's and guarantor's finances, such as annual and sometimes quarterly financial statements. Some leases go further and include financial covenants, for example a minimum net worth or a limit on distributions, with default or additional security as the consequence of a breach.

Reporting is normal and reasonable to accept, with confidentiality protections. Financial covenants in a lease are a different matter. They can turn a difficult year into a lease default even when rent is paid on time. If an investor insists on them, negotiate the consequence down to a cure such as posting additional security, and make sure the covenant definitions match those in your loan documents.

1. Map your corporate structure and decide which entity should be the tenant before any offer is requested.
2. Prepare financial statements for that entity and for any likely guarantor, so investors are underwriting facts.
3. Ask bidders to state required credit support in their offers, and to price alternatives.
4. Compare offers on price and exposure together, not on price alone.
5. Negotiate caps, burn-offs and release conditions at the letter of intent stage.
6. Have counsel align the lease, guaranty and any letter of credit so their default and release terms agree.

As the occupier's representative, we treat credit support as part of the price discussion from the start, so owners see the full cost of each offer and are not asked for a personal guaranty late in the process when alternatives are gone.