First, I’ll just get it out of the way and let you know I’m not talking about getting bailed out by the government. Although, becoming “too big to fail” is a good place to be.
So, what is the mechanism by which banks seem to always be protected? Banks are in the business of extending credit, and making that work for them. If there are lessons to be learned about extending credit in a manner that protects, and enhances, your bottom line, looking at banks is good way to start.
Deciding to Extend Credit
Before extending credit, whether by performing work, delivering materials, or something else, certain factors must be considered, all of which boil down to risk assessment. Factors to consider prior to making a decision about extending labor or materials on credit can include: the size of the business to which credit will be extended, its business credit score, any past relationship, the amount of credit to be extended, and so on.
If credit is to be extended, you need to make a reasonable determination of how likely it is that you are going to be paid. Extending labor and/or materials on credit opens up the possibility of your business being burdened with bad debt. And, since the actual cost of bad debt is many times greater than the amount of the bad debt itself, it clearly makes good business sense to insulate your business’s exposure to this type of situation. While, practically, it may be very difficult, if not impossible, to completely eradicate bad debt, there are ways to drastically limit your potential exposure and to maximize profit – all without resorting to an overly restrictive credit policy.
Security: The Tool That Gets You Paid
When you are able to secure the extension of credit, the likelihood of payment skyrockets, and the extension of credit can be approached in that manner. It’s no secret that a secured creditor is in a much better position to be paid than a general unsecured creditor.
So, what is secured debt, and how should your company’s credit policy deal with it?
This is where a construction credit manager can take some hints from the banking industry. Banks secure every extension of credit they make, and if they didn’t there would be a lot of bankers looking for new jobs. If a tool exists solely for the purpose of guaranteeing that you are paid for work you do or materials you furnish, that tool should be used. Just like you wouldn’t expect a bank to give you a loan for a house or car without gaining collateral to guarantee your repayment, construction credit professionals shouldn’t extend credit without taking the steps necessary to secure it via mechanics lien or bond claim rights (or ucc liens, or personal guarantees, etc., etc.). Secured debt is a debt backed by a security interest in collateral. Securing the extension of credit with collateral reduces the risk associated with lending or extensions of material on credit. If a debt is “secured”, it is backed by a right in an asset that may be claimed by the lender in the event of a default by an indebted party.
A security interest may be voluntary or involuntary. The specific type will have an effect on the structure of a credit policy crafted to take advantage of the benefits of securing debt. A voluntary lien is something that must be agreed to by the parties. This agreement typically occurs as a condition to the extension of credit and therefore should take place prior to the decision on whether to extend credit or not. An example of voluntary security that can be incorporated into a credit policy is a UCC lien. An involuntary lien arises through operation of law, whether or not the indebted party consents (provided the proper steps are taken). An example of this is a mechanics lien.
Long story short, security is the tool that gets you paid. It protects against debtor default, and provides leverage to prompt payment prior to the last step of foreclosure. Professionals in the construction credit space can learn this lesson from professionals in the banking sector – being secured won’t hurt you, but being unsecured may.