A small business owner may form a LLC or a S-Corp for the business in order to protect themselves from personal liability for the acts of the business entity. However, when it comes time to sign a commercial lease, it may be impossible to completely insulate the owner’s personal finances from the fortunes of the business. This is because many commercial leases – and particularly those for small businesses or businesses just starting out – will require that the business owner provide a personal guarantee as a term of the lease.
In a personal guarantee, the guarantor (usually the business owner) agrees to be responsible for the lease payments owed by the business under the terms of a commercial lease if the business fails to pay rent or fails to pay rent after vacating the leased space before the end of the lease term. Typically, a commercial lease will provide that if the tenant (the business) fails to pay rent, the landlord may collect against the personal guarantor. In other words, if a business fails to pay its rent under a commercial lease, the landlord wants someone it can collect the rent from other than the business entity itself.
Why do landlords require personal guarantees for commercial leases? Simply put, the landlord wants to make sure that it can collect the rent owed to it for the leased space. If a business is struggling and can’t pay rent, the business may fail and cease to exist before the lease term ends. When a business closes shop, the business entity that signed the lease may have little or no assets remaining to pay the rent due for the rest of the lease term. Further, if the business ceases to operate, it won’t have the income it needs to make the remaining rent payments. When a business fails or is otherwise unable to pay its rent, the landlord’s recourse is to collect the rent that the business would otherwise have paid under the terms of the lease from the guarantor.
Just as not all commercial leases are identical, not all personal guarantees carry the same terms. Business owners may be able to negotiate terms that can help reduce their personal risk. For example, a landlord may be required to “mitigate” its damages by renting the leased space to a new tenant as soon as possible. If another tenant occupies the space during the lease term, the personal guarantor would be on the hook only if the new tenant’s rent was less than the amount secured by the guarantee. If that were to happen, the guarantor would only be liable for the difference between the rent due under the original lease and the actual rent paid by the new tenant. Another way to reduce risk for guarantors is to include the right for the business to assign its lease to a new tenant, so that if the business is sold or otherwise must close, a new business tenant occupying the space will be responsible for the rent. Finally, if a commercial lease has more than one individual providing a personal guarantee, the guarantors may be able to reduce the amount of individual risk by reaching an agreement among themselves to assume joint responsibility for the rent if the business fails to pay rent.
Investing time in negotiating a commercial lease that includes provisions mitigating liability under any personal guarantee makes good sense for businesses, and for business owners. Questions about your commercial lease? We can help! Our firm enjoys working with businesses to negotiate commercial leases.