The Founder’s Guide to Finance: “Bad Boy” Guarantees

Given you’re reading this guide, we’re going to assume you received a term sheet from a lender with “Bad Boy Guarantee”, “Bad Boy Guaranty” or “Bad Boy Guarantor” specified in the T&C and were caught off guard. To be honest, when we first saw a term sheet with this clause in it, we too were a bit taken aback. But no need to worry, as it's pretty straightforward and doesn’t apply in most cases. We outline what it is, in what scenarios it applies, and what happens if triggered below. Let’s dive in!

An overview of “bad boy” guarantees - what they are (and aren’t)

A “bad boy” guarantee, also known as a recourse guaranty or nonrecourse carveout guaranty, essentially makes the founder or executive team of a startup personally liable for a loan issued to the startup, if a “bad act” was committed by the guarantor or its principals. They can be structured so that the borrower, guarantor, or both, are personally liable for damages to the lender, or so that an otherwise nonrecourse loan is converted into a full-recourse loan against the borrower or guarantor, or both. You can think of  “bad boy” guarantees as a form of personal guarantee.

Actions that can trigger a “bad boy” guarantee (and an example)

Several actions can trigger a “bad boy” guarantee. The first, and most common is fraud, which may include misrepresentation of the business's financials. The second is misapplication or misappropriation of funds, such as for personal benefit rather than legitimate business expenses. The third is the unauthorized transfer of the underlying collateral (asset, inventory, machinery…etc.). The fourth and final is default or bankruptcy filing. Here’s an example of a “bad boy” guarantee in a real term sheet:

“Personal liability of the principals is triggered for (i) fraud, gross negligence, misappropriation of funds, criminal acts & material misrepresentation; (ii) hindrance of the Lender’s security interest which results in the direct actions of the principals; and (iii) unpermitted transfer.”

What happens when the “bad boy” guarantee is triggered

If this provision is triggered, as mentioned above one of two things will happen, either the guarantor or the principal of the startup will assume liability for the loan or the loan will become full recourse. Neither scenario is ideal, as this provision may trigger other provisions simultaneously, leading to the lender prematurely recalling the loan—resulting in an immediate repayment. That’s why typically in negotiations the principals and guarantors of the loan will push for limitations around the scope of the liability, typically to just the amount of actual damages, rather than the total amount of debt.

The application of “bad boy” guarantees in the mortgage industry

Historically “bad boy” guarantees were used in mortgage agreements, where lenders looked solely at the underlying collateral (the property) to satisfy the debt if the borrower failed to perform its obligations (repay the loan). That worked well when the underlying value of the property was higher than the outstanding debt balance, however, with such drastic fluctuations in housing prices over the past decade (especially so post-covid) borrowers could quickly become underwater. In those situations, the banks were effectively out of luck if the borrower defaulted on the loan, thus the need for “bad boy” guarantees.

The application of “bad boy” guarantees in startup land

A similar thing happened with startups during the COVID bubble, as did with mortgages. Startups (and founders) took out loans against collateral with largely inflated valuations and subsequently went bust. The banks ended up “holding the bag” with the underlying collateral, now worth just a fraction of what they were one year prior. To combat this, the banks created and enforced “bay boy” guarantees to ensure the startup borrowers didn’t misappropriate funds, didn’t pledge the same assets to multiple lenders, and didn’t prematurely file bankruptcy actions. In such cases, the principals (founders, executives, or board members) were held accountable for the losses suffered by the lender as a result of such acts.

The danger of standard recourse carve-out provisions

Many term sheets refer to the lender's "standard recourse carve-out provisions," without delineating the particular events that trigger personal liability in an otherwise non-recourse loan transaction. Given “bad boy” guarantees can turn otherwise non-recourse loans into full-recourse loans, there is significant risk. Startups should request that the lender specify the exact terms of the recourse carve-out provisions in the term sheet so that the guarantors can make an informed decision at the outset of negotiations. In most cases, if asked, lenders will let you review their standard “bad boy” guaranty, ahead of signing—this is when the terms should be negotiated.

The danger of “bad boy” guarantees in mezzanine financing deals

Mezzanine financing is a hybrid form of debt and equity financing, similar to a SAFE or convertible note, except that it gives the lender the right to convert its debt position into an equity interest in the event of default. When combined with a “bad boy” guarantee, this can be a recipe for disaster. Say for example a startup is on the verge of defaulting on a loan (but not declaring bankruptcy). Instead of defaulting, the startup agrees to convert the debt component into equity. In some cases, the lender now has controlling interest, which means they can put the startup into bankruptcy, thereby triggering the guaranty against the guarantor. Thus making the principals responsible for repaying the loan balance. This doesn’t happen often, but when it does, it's a mess—so it’s best to avoid this combination all together.

Wrap up - our thoughts on ​​“Bad Boy” Guarantees

The reality is that in most situations, “bad boy” guarantees are not relevant, and will not be triggered. Unless you commit fraud, misappropriate funds, transfer collateral without prior approval, default on the loan, or file for bankruptcy, it does not apply to your startup. If you are worried about it, consider negotiating the terms, so that the liability is limited to the specific damages caused, rather than the entire outstanding loan balance. If possible, avoid agreeing to “bad boy” guarantees if you’re pursuing mezzanine financing and get clarification around the specific events that trigger personal liability in otherwise non-recourse loans. Check out this guide for the other covenants, clauses, and provisions to avoid.