Question of the Week
In this economic climate of rising inventory costs, I am concerned that my business will be caught short of cash if my customers do not pay me as quickly as I must pay my suppliers. Are there any legal tools I can use to improve my company's prospects of being paid timely?
Inexperienced businesses and those without formal business plans often overbuy from their suppliers. When their credit terms have expired, they may not have generated enough sales to pay those suppliers. What usually happens next is a progression of dunning letters, bad feelings, and a collection action, with no appreciable positive effect on your cash flow. If a credit check or your gut feeling tells you that your buyer is ordering too much, without thought, and flirting with illiquidity, consider asking the buyer to provide you with a form of payment insurance.
If you are using open account billing, here are two forms of payment insurance that may help you and a prospective buyer agree upon credit terms.
Standby Letters of Credit aren't well known to businesses operating below the canopy of large corporations, but they represent an effective way to guarantee the buyer's payment on a big order. A letter of credit is a payment instrument where a buyer pays a seller through their respective banks. Letters of credit are preferable in some ways to personal or business checks because they substitute a bank's obligation to pay you in place of the buyer's obligation. A standby letter of credit is just that, it is a bank's obligation to pay you in case the buyer defaults on your terms.
Letters of credit cost money. The cost is often fixed as a percentage of the buyer's obligation to you plus certain fixed fees. Letters of credit get more economical as the amount of the obligation increases. A $10,000 credit may cost $400. A $100,000 credit may cost only $500. The costs of credits vary widely depending upon the type of credit applied for and the creditworthiness of the buyer. The buyer's bank will determine the costs according to its policies.
Proposing a standby letter of credit to a customer with a big appetite for your wares but little history may allow you to get the new account, give the buyer the competitive terms they want, and give you the downside protection that you want. While it is the buyer that customarily pays the cost of the credit, you may decide to split the cost, reimburse the buyer, or lower your total price accordingly to encourage the buyer to apply for the credit. Paying the buyer's fees may seem unorthodox at first, but the cost of the credit to you now will be far less than the cost of an unpaid account on a large order. If a buyer cannot get a credit, or refuses to try, it may be a sign that they are not creditworthy, and you should steer clear.
A guaranty is a written promise, like a contract, by a person or company to pay your buyer's obligation if the buyer defaults. Guaranties are typically used where a start-up borrows money or asks for credit. The guaranty usually comes from the well-established individual or company backing the start-up. As the seller, a guaranty gives you a source of money to look to in case the start-up fails, and thus offers you an added measure of security.
The advantage of a guaranty is that it does not cost anything, excepting legal services costs when drafted by an attorney. Another advantage is that you can usually convince a small or start-up buyer to get a guaranty from their backers for you, especially if the parties involved really believe in the buyer's start-up business.
The main drawback of a guaranty is that you cannot present it to your bank for payment like a letter of credit. The only way to collect on a guaranty is to request payment from the party that issues it, the guarantor. If that does not work, you may have to take legal action to collect on the guaranty.
No payment system or payment insurance is perfect. In spite of your most diligent efforts, you may from time to time experience a cash flow that is less robust than you would prefer. If you would like to improve your cash flow, think about these different forms of payment and payment insurance. Find a payment area where you may be under competitive, or conversely, making it too easy for buyer's to fail to pay you. Get paid, and bring some more life into your business.
For more information, please contact Michael Cavendish.
