Guarantee Facility

What is a guarantee facility?

Guarantee facility (German: Avalkredit, Aval for short, also Bürgschaftskredit; also called guarantee credit) refers to a bank's assumption of a surety or guarantee on behalf of a company towards a third party. The bank does not provide liquidity but its own creditworthiness: it pays the beneficiary if the company fails to meet a contractual obligation. This is why it is described as a lending of credit standing (Kreditleihe), as opposed to a lending of money (Geldleihe). A familiar example is the rent deposit, which is not placed with the landlord as cash but guaranteed by the bank.

Three parties are involved: the company as the principal, the bank as the guarantor (Avalgeber) and the company's contractual counterparty as the beneficiary, such as a customer, a landlord or an authority. The basis is the guarantee facility agreement (Avalkreditvertrag) between the bank and the company and the guarantee document that the bank hands to the beneficiary. Usually both agree an Avalrahmen (guarantee line, also Avalkreditlinie), often as part of an overall credit line; up to its amount, the bank issues individual avals on request.

Legal basis of the guarantee facility: surety and guarantee

The surety is regulated in Sections 765 et seq. of the German Civil Code (Bürgerliches Gesetzbuch, BGB). It is accessory, that is, dependent in existence and scope on the secured principal claim. The bank can therefore rely on the company's objections and defences against the claim (Sections 767 and 768 BGB). Bank sureties are generally direct (selbstschuldnerisch): the beneficiary does not have to proceed against the company first and enforce against it. The right to demand this (defence of prior action, Section 771 BGB) is not available to a bank as a merchant in any case under Section 349 of the German Commercial Code (Handelsgesetzbuch, HGB).

The guarantee is not regulated by statute. It is an independent promise to pay that applies irrespective of the existence of the secured claim, and it is widespread in international business. With sureties and guarantees on first demand, the bank pays upon the beneficiary's formally correct demand. Whether the insured event has actually occurred is clarified only afterwards in a dispute over repayment; the bank may refuse payment only in cases of obvious abuse of rights.

Avals are issued without a fixed term or for a fixed term. With a surety for a limited period (Section 777 BGB), the bank is in principle released once the agreed period has expired. This does not apply if the beneficiary notifies it without delay that it is making a claim. Bank documents often also provide that a claim must have been received by the bank by the end date. A fixed term limits costs and the burden on the credit line but is not accepted by every beneficiary.

If the bank pays, it takes recourse against the company. In the case of a surety, the beneficiary's claim passes to it under Section 774 BGB, and it also has a claim for reimbursement under the guarantee facility agreement. The aval thus turns into a cash loan, which is generally due immediately. The risk of a claim is therefore borne economically by the company alone.

Types and uses of the guarantee facility

• Rent guarantee (Mietaval): replaces the cash deposit in commercial leases. There is no statutory ceiling here as there is for residential property; several months' rent is usually required.
• Advance payment guarantee: secures the repayment claim of a customer who pays before delivery. It allows projects to be pre-financed with the customer's money instead of the company's own funds.
• Performance guarantee: secures the proper execution of a contract. Public-sector clients and industrial customers often require it for larger contracts.
• Warranty guarantee: secures claims for defects after acceptance. It replaces a retention of security, that is, a part of the invoice that the customer otherwise withholds until the end of the warranty period. A small percentage of the contract value for the duration of the warranty period is customary.
• Customs and court guarantees: towards customs authorities, for example for a deferral of payment of import duties, or in court proceedings as security for the opposing party, for example to be able to enforce a judgment that is not yet final.

For technology companies, the rent guarantee as well as advance payment and performance guarantees on hardware projects and larger software implementations are usually the main cases.

Costs, guarantee line and accounting

For the aval, the bank charges a guarantee commission (Avalprovision) as a percentage of the guaranteed amount per year, often quarterly in advance. Its amount depends on creditworthiness, the type and term of the aval and the collateral; fees for issuing the guarantee document often come on top. Because the bank provides no liquidity but only bears the default risk, the aval is generally cheaper than a cash loan of the same amount.

An aval is not a cash loan but counts towards the bank's credit risk. The bank counts it against the customer's overall line and, under banking supervision rules, must back it with equity. If a company uses part of its overall line for avals, the room for the overdraft facility shrinks accordingly. A separately agreed guarantee line makes this competition visible.

The aval does not appear on the company's balance sheet as long as the bank does not pay. What is recognised is the underlying obligation of its own, such as an advance payment received under liabilities or a provision for warranties. The company records the guarantee commission as a current expense. The bank carries the aval as a contingent liability, that is, an obligation that leads to a payment only in the insured event. Buyers and investors therefore demand a schedule of avals in due diligence, their review of the company before investing or buying. It is reconciled with the credit exposure statements (Obligoauszüge), in which each bank lists all of the customer's loans and avals, because the extent of open avals often does not emerge fully from the annual financial statements.

Guarantee facilities for young technology companies

The bank assesses an aval like a cash loan, even though no money initially flows: earning power, equity base, liquidity and the likelihood that the insured event occurs. Young technology companies without positive results therefore often obtain avals only against cash collateral, that is, against a pledge of a balance equal to the aval or to part of it.

With full cash collateral, the liquidity advantage over a cash deposit largely falls away. With a growing revenue base and stronger creditworthiness, the collateral can often be reduced step by step. As a complement to equity, the guarantee facility is worthwhile above all where it makes customer advance payments possible in the first place. The customer then pre-finances the project, and the equity raised remains available for product and growth.

Avals in a company sale

In a company sale, avals must be reorganised by closing. They depend on the target company's credit relationship with its bank. If the acquirer moves the financing to its own banks or the loan agreement contains a change of control clause (change of control), running avals must be released or replaced. This requires the cooperation of the beneficiaries, who must return their guarantee documents.

In the purchase price calculation, avals not drawn on generally do not count towards net financial debt. Cash-collateralised balances, by contrast, are not freely available and are often not recognised as free liquidity. This can reduce the equity value, that is, the purchase price for the shares. Open warranty avals show for which completed projects claims for defects may still exist.

Worked example: costs of a guarantee facility in project business

A manufacturer of measuring systems with its own evaluation software receives an order worth EUR 1.2 million. The customer pays a 30% advance payment against an advance payment guarantee and, after acceptance, requires a warranty guarantee for two years of 5% of the contract value. At the same time, the company rents new office space; the landlord requires rent security of six months' rent at EUR 12,500 each. The overall line at the company's main bank is EUR 800,000, the guarantee commission is assumed to be 1.5% per year, and the overdraft interest rate is assumed to be 8% per year.

• Advance payment guarantee: 30% × EUR 1.2 million = EUR 360,000, term of eight months until delivery
• Guarantee commission for it: EUR 360,000 × 1.5% × 8/12 = EUR 3,600
• For comparison, pre-financing the same amount through the overdraft: EUR 360,000 × 8% × 8/12 = EUR 19,200 in interest
• Warranty guarantee: 5% × EUR 1.2 million = EUR 60,000; commission for two years: EUR 60,000 × 1.5% × 2 = EUR 1,800
• Rent guarantee: 6 × EUR 12,500 = EUR 75,000; commission: EUR 75,000 × 1.5% = EUR 1,125 per year
• Burden on the overall line during the project: EUR 360,000 + EUR 75,000 = EUR 435,000; free for the overdraft: EUR 800,000 minus EUR 435,000 = EUR 365,000
• After acceptance: EUR 60,000 + EUR 75,000 = EUR 135,000 of avals; free for the overdraft: EUR 800,000 minus EUR 135,000 = EUR 665,000

The advance payment guarantee costs EUR 15,600 less than pre-financing through a cash loan. The calculation also shows the bottleneck, however: during the eight months of the project phase, only EUR 365,000 remains available for the rest of the working capital requirement. If a second order with an advance payment comes in at the same time, the overall line is not sufficient without an enlarged guarantee line.

Distinctions: guarantee facility, letter of credit, cash deposit and collateral

• Letter of credit (Akkreditiv): a bank's promise to pay in foreign trade that protects the seller against the buyer's payment risk. There, the bank pays against presentation of agreed documents, not only on non-performance.
• Cash deposit: placing a sum of money with the beneficiary. It ties up liquidity for the entire term and creates only a repayment claim against the recipient.
• Collateral: The aval is itself a security for the beneficiary; for its recourse, the bank in turn has the company provide collateral.

Common mistakes

• Completed avals not reclaimed. Avals without a fixed term continue until the beneficiary returns the guarantee document or releases the bank from liability in writing. Until then, commissions accrue and the line remains encumbered.
• Accepting first demand without need. This form allows access to the bank before entitlement has been clarified; the recourse risk falls immediately on the company.
• Guarantee line not planned separately. If avals and overdraft are served from one overall line, a large order with an advance payment can unnoticed use up the room for working capital.
• Wording of the guarantee document agreed too late. If the text required by the customer deviates from the bank's standard, issuance is delayed; the agreement belongs before the signing of the customer contract.

Frequently asked questions

When does an aval end?

With the return of the guarantee document to the bank, a written release from liability by the beneficiary, or the expiry of a period agreed in the guarantee document if no claim has been made by then. Mere completion of the order is not enough; the bank needs proof that it can no longer be claimed against.

Can a landlord refuse a bank surety instead of a cash deposit?

Yes, if the lease provides for a cash deposit. The type of security is a matter for negotiation and is best clarified before the contract is concluded. Many landlords accept a direct, unlimited-term surety from a bank or a surety insurer.

Is there a guarantee facility for private individuals?

Yes, above all as a rent surety from a bank or a surety insurer instead of the cash deposit. For residential property, the rent security may amount to no more than three months' rent under Section 551(1) BGB, calculated without the service charges shown as a lump sum or advance payment.

Are there avals without a main bank?

Yes, through surety insurers. They issue sureties from their own guarantee line, which does not burden the main bank's credit lines. The creditworthiness check follows its own standards; some business history is generally required.

Why does the bank require collateral for an aval although no money flows?

Because the insured event typically occurs precisely when the company is in difficulty. An advance payment guarantee is called, for example, when delivery does not take place. In that situation, the bank's reimbursement claim is often no longer enforceable without collateral.

The Roemer Capital view

For companies with project or hardware business, we draw up before a funding round a schedule of all open avals with beneficiary, amount, term and cash collateral. We reconcile this with the banks' credit exposure statements. Not infrequently, it includes avals for projects that were completed long ago; returning them creates room on the line without any new financing being needed.

In a sale process, this schedule belongs in the data room. We clarify early with the acquirer which avals it will release or replace at closing, so that the exchange of guarantee documents between signing and closing of the purchase agreement does not become a bottleneck. The contractual implementation lies with the parties' law firms.