«Guarantees in Business Financing: Understanding Its Role, Use, and Distinction»
When we talk about a guarantee, we’re referring to a commitment assumed by a third party to answer for the financial obligations of another company, thereby assuming the role of guarantor in case the financial obligation is not paid. In simpler terms, a guarantee is a kind of insurance that a third party provides to a financial institution to cover the non-payment of another entity.
Financial institutions, such as banks, frequently ask for this assurance before granting loans to businesses, with the aim of ensuring the recovery of the loan amount in the event that the borrowing company does not fulfill its obligations. The guarantee, therefore, acts as a safety net for the lender and can facilitate the approval of the loan for the borrower.
However, it’s important to point out that a guarantee differs from performance guarantees. The latter ensure payment or compensation in the event of insufficient or delayed performance on the part of the contractor. In contrast, a guarantee is a promise to assume the financial obligation if the debtor entity cannot do so.
The guarantee plays a crucial role in the continuity of projects. It serves as a mutual benefit for both the borrower and the financial institution, ensuring that projects are not interrupted by financial problems and that lenders can recover their investment.
Let’s look at a more practical example of how a guarantee works:
Imagine a company, let’s call it Company 1. It would need a certain amount of financing for one of its upcoming projects. However, the bank looks for some security that, if Company 1 fails to perform or complete and does not return the money, it will need the backing of another significant entity in terms of a guarantee if there is any default by it. Company 1 would now seek assistance from another friendly or parent company with significant net worth. The bank would be satisfied that the entity carrying out the activity will fulfill all its obligation and the default will have sufficient backup from the parent company. The parent company, Company 2, would now act as a financial guarantor if Company 1 incurs any default in its timely payments to the banks, and the bank is insured and has the right to claim the same from Company 2 if the need arises due to defaults, if any. It also happens that there are occasions when more than one guarantor provides the underlying guarantee. In such circumstances, each guarantor would have to be responsible for the prorated portion of the problem. Sometimes, the parent company may also guarantee the bonds that its subsidiary company issues, which also serves as an example.
Another example could be:
Company 3, a subsidiary of Company 4, wants to venture into the construction of a magnificent residential society in Madrid and needs an amount of $2 million for this. It approaches Banco Santander to finance this end. The bank agrees to do so, but on the condition that the parent of the subsidiary, Company 4, acts as guarantor in this regard and agrees to make the payments if the subsidiary Company 3 incurs any default in its timely payments relating to the interest and principal components of the loan. Company 4, towards this end, comes forward to act as a financial guarantor for Company 3. This act can be considered as a form of a guarantee. In the future, if Company 3 starts to default on its obligations, Company 4 will be called upon in its role as guarantor to make the timely payments required by Company 3. Therefore, Large Co becomes an important financial guarantor for its subsidiary, Company 3.
Another example could also be a shipping company seeking to guarantee the value of a particular shipment from a maritime insurer who would act as the guarantor of the guarantee in this case.
Why do we use it?
When a company or business owner decides to embark on a risky project and needs to borrow from a financial institution, the latter is concerned about the recovery of its investment. For this reason, it requires a security mechanism for repayment, in this case, the guarantee. The guarantee ensures that there are no delays in obtaining the necessary financing for the project and assures the bank that its loan will not become a non-performing asset.
Difference between guarantee and performance bond
A guarantee tends to make the payment by the guarantor if the borrower does not make the required payments on the loan amount. The guarantor would be obliged to make the payments on behalf of the borrower. If any default occurs, it is then that the guarantee comes into play. On the other hand, a performance bond ensures the payment or any compensation in case of insufficient or delayed performance on the part of the contract party. It tends to indicate that if the party does not meet its standards in terms of expected performance, it is then that the guarantor will take up the required responsibility to pay the guaranteed money. Suppose that, if one were to purchase certain equipment, but it does not meet the expected standard or does not fully comply, then the guarantor has the responsibility to compensate the loss.
Therefore, the guarantee presents itself as an essential mechanism to ensure the continuity of projects, acting as a safeguard for the contractor and benefiting both the borrower and the financial institution.