The Use Of Credit In Managing Downstream Relationships

Author Richard Solomon is a conflicts and crisis management lawyer with 50 years of experience in business development, antitrust and franchise law, management counseling and dispute resolution including trials and crisis management.

Everything, every aspect of everything in managing the downstream relationship among vendor/manufacturer/franchisor and those who are purchasers for use in their own businesses is a metric issue. Most tend to think of buy/reject decisions in customer selection and termination processes. There is, however, an in between aspect that is often overlooked when sorting out relationship quality. The extension of credit is usually viewed as a sales tool. That thinking is often dangerous. It assumes an entitlement at the customer end of the equation. The extension of credit is often a trap for the seller.

Credit costs money. Many producers have to borrow money to finance their receivables, often at significant expense. Retailers and other customers seek generous credit terms to avoid that financing expense as well as to maximize their cash flow. The more favorable credit terms they receive, the more important they believe they are to the business health of the seller, the more entitled they become in attitude. The more they can owe and the longer they can get to pay up, the weaker the seller control becomes.

The downstream incentives are extremely attractive. The purchaser is trying to get his payables aging to match or exceed his receivables aging. In some instances the reselling purchaser is actually making money on his vendor's money because he is getting paid in full for things he does not yet have to pay his producer for. The producer is not only financing his own receivables, but he is also financing his customers' receivables.

Since the producer's accounting system makes it look like there is no "cost" in doing that, it does not at first glance appear to be affecting producer profit. To be sure, notes payable appears as an entry in any financial statement, but how much of notes payable is required to be serviced due to producer's extensions of credit to its customers cannot be broken out. At some point the accounting rules require write down of aging receivables, and then the impact upon net revenue becomes visible.

Regardless of the lag between onset of destructive credit policy and the point at which write downs are required, there is an economic cost that is real even though it may not appear on the operating statement. On the balance sheet these receivables actually contribute to the asset value of the company, as they are counted as assets. This is fairytale accounting/economics. Cash flow is the more realistic picture of company capital value, although cash flow may not account for what the company is doing with the funds accruing from noncash deductions like depreciation and amortization. Frequently that is going to debt service in rather large percentages. That is why EBITDA is so useful, except that the amount of interest attributable to financing receivables is more pernicious than is revealed in any periodic report. Source and application of funds reports help insight here. The further you have to look to find a semblance of reality, the weaker is the company whose report you are looking at.

Out of order credit terms always signal to your customers that you are weak, to be preyed upon like any animal eats weaker animals. You may eventually become successful enough that you can afford, without failing, to terminate those who owe you a lot of money and refuse to pay up, but that is unlikely. Usually they just eat you alive. Strong producers do not give out of line credit terms. It really is better to terminate customers who consume your resources by pretending to buy from you but are never really buying because they are not required to pay up. That's right. They see you as Santa Clause, not as a respectable business person.

I suppose the worst credit policy I ever saw involved a franchise company that failed to police prompt payment of royalties and advert fund obligations. The intent was to help franchisees find their way to profitability as well as get the aging and almost worthless receivables off their books by converting them to notes receivable that were not due until the end of the franchise terms.

Eventually these amounted to over a million dollars, all carried as assets on the company's books. These franchisees found each other at franchisee conventions and decided that it would be better for them to sue the franchisor; get out of the franchise; beat the covenant not to compete; and continue in the same business as independents. When I took their depositions using their tax returns as exhibits, almost all of them were already profitable and just cheating on the royalties and advert payments. They lied about the reason for tardiness and got the convert into notes accommodations. Their emails to the franchisor showed they were lying about their financial conditions. Their emails among themselves also showed that they joked among themselves about how stupid the franchisor was and how easily deceived.

That franchisor deserved their lawsuit for $62,000,000 on grounds of alleged RICO violations for being so stupid as to extend that kind of credit without adequate due diligence, as well as for the inappropriate purpose of making its financial condition look better than it was. Those who sued for $62,000,000 ended up paying us almost a million dollars to get out of the case. Their allegations were not supportable, but the search for the evidence required a lot of expertise.

The lesson is that this was a fluke. Most tactics like this end up in disaster. The franchisor shot himself in the foot - to put it nicely. The "helping" mechanism was actually a fraudulent book keeping scheme to avoid its own debt acceleration due to loan covenant breaches. They dodged both bullets because of the settlement that got rid of the lawsuit potential liability and recovered a substantial amount of the franchisees' debt. In most instances that kind of case would cause the company's accountants to refuse to give any kind of "going concern" clearance in its audit letter. It almost did in this case. Handling the auditors was almost as difficult as handling the case itself.

There is a natural abrasive interface between sales and credit management. That exists in every company. But someone has to make the tough calls on credit, or else.

Your biggest customers with your best credit arrangements can gradually become knives at your throat. It is eventually no longer a case of you terminating those customers. You come to believe that the cost of termination is just too high because of the deterioration in value of those receivables produced by the decision to terminate.

The more credit you give, the greater is the likelihood that you will also incur litigation expense and disruption if your customer's conduct becomes intolerable. Your arrogant customer to whom you extended extraordinary credit becomes more belligerent and starts threatening you. Consequently that customer behavior becomes more and more arrogant and disruptive. That causes deterioration in your relations with your other customers, who by then have learned of the extent of credit favoritism enjoyed by the disruptor.

This cycle is absolute. There is no way out once it is in place and the disruptions occur. Those receiving preferential terms will always brag about it. There are no secrets, no matter what you think of the value of confidentiality. You are allowing your desire to get along to destroy your business. Exercising control over the situation takes courage. Lack of that courage carries a very high price. You have to use credit as a control muscle to avoid this inevitable crisis.

The establishment of credit limits with new customers has to be strict and small. It will expand of its own weight as the relationship continues. Even then there have to be limits that are economically intelligent - which also means not destructive of your control over your own downstream chain.

Credit should also be used as a discipline mechanism. If you keep it within reason, it can be withdrawn or reduced to bring disruptive customers back in line. It should be played like a musical instrument. Governance and prophylacsis are the best mode. There are grace notes, nuances in credit management that include such things as late fees and interest. Late payers should be given a chance to get straight, but only with documentation of the event that includes releases and specific consents to the imposition of fees and other charges should the slack payments recur.

This documentation will provide very useful exhibits when disputes get out of hand. Interest may not be that big a whip due to state usury laws, so there have to be other whips. Use them when they fit the situation. Your appearance of strength will be your biggest ally going forward. If your financial condition and business performance are marginal, credit management will not be meaningful to you. If you are really weak everyone will know it. In many businesses there are companies that specifically search for weak vendors that are easily exploitable. Weakness in business works just like weakness in any other jungle.

Withdrawing credit entirely is an available discipline mechanism only when the producer is perceived as strong (whether that is right or wrong). But you never want to get to that point. When you are there, you have seriously failed to protect yourself. Sometimes you have to bite bullets as a survival tactic. In the end it will pay off handsomely if you survive. If you don't do it this way you are probably not going to survive anyway. You will just be ground up and fed to your own creditors.

You do not have to call a customer's attention to his misconduct. He already knows what he is doing and what its implications are. You simply give notice that effective 60 days hence the new credit terms will be such and such, and that payment must be made now in order to come into compliance with the new credit terms. That message will soak in with him and will resonate throughout your distribution chain, because he will whine about how he is treated. You may even get a threatening letter from his lawyer, which you answer with a simple statement that your credit terms are discretionary at your option.

Never give a reason for the change, as that may limit your options in the event of a real dispute. They already know what the reason is. As the customer demonstrates a history of returning to correct behavior, you may gradually reinstate improved credit arrangements. Credit becomes a carrot as well as a stick and serves its purpose to you in a more effective manner.

The customary approach to credit management, in addition to being a constantly adverse reconciliation of sales and credit, is the apparent creditworthiness of the customer. That is but a starting point. The naked observable statistic on credit reputation in the market as reflected by credit reports is but a first step in credit worthiness assessment. One may well posit that customers who play aggressively vis--vis normal market behavior are inherently more likely to play aggressively with credit privileges unless restrained. If you are not following a competent credit watch, the one you think is your best customer may well be in a zone of insolvency and about to file bankruptcy, leaving you as an unsecured general creditor in most instances.

There are practically no competition law concerns with using credit management beyond the most obvious credit report dimensions. What is regulated/prohibited in that sense does not involve different credit terms across the customer landscape. It is universally accepted that credit terms should be left unhindered, because its management is more high risk for the seller than market behavior disruption risk generally is for market health.

He who wallows in high sales that are associated with 90 day receivables is courting trouble. Resellers are expected to manage their own receivables to approach equilibrium between payables and receivables, but there is no entitlement to that. Their producers are not in any manner obligated to be lenders by compulsion, and they place themselves at unreasonable risk by allowing advantage to be taken by obvious opportunists.