Ideas for Extending Credit to a New Business
C. Dennis MBA,
From time to time, credit professionals will receive a credit application
from a newly formed company. In some cases, the company in question
is well financed, the owners or senior managers have a wealth of
experience in the industry...and consequently the company has a certain
amount of credibility with customers and vendors.
A more difficult situation arises when the applicant is new to
the business and has no trade references, a non-borrowing bank relationship,
and reports that the company has no financial information to share
with creditors. The question to consider is this:
How can vendors
sell to this second type of credit applicant while controlling and
limiting credit risk? Limiting risk in this scenario will not be
easy. Some of the more common tools used, or used in combination to
risk are shown below [in descending order of importance as an effective risk
Ask this new customer to arrange for its bank to issue a documentary
letter of credit. A documentary L/C substitutes the creditworthiness
of the issuing bank for that of the buyer. The seller will be
paid if it presents conforming documents to the issuing bank
within the deadlines established under the letter of credit and
under the rules established for administering letters of credit
[called the UCP 500].
Ask the customer to arrange for a standby letter of credit.
A standby letter of credit is a secondary payment mechanism.
A bank will issue a standby letter of credit on behalf of its
customer to provide assurance of the debtor company's ability
to pay a specific creditor named in the L/C. Normally, neither
the seller nor the buyer expects that a standby L/C will be drawn
upon. Standby L/Cs are used only if the debtor company fails
to pay the creditor company.
Require the customer to pay C.O.D. on small orders and cash
in advance on large or custom orders...with the understanding
that after three to six months of purchasing on C.O.D. and C.I.A.
terms that the customer will be considered for open account terms.
A note of caution: It may seem counter-intuitive, but selling
on C.O.D. Cash terms can result in bad debt losses. Common carriers
do not allow their drivers to accept cash payments, so C.O.D.
cash terms means that payment is due on delivery in the form
of a cashier's check or money order. If the driver accepts a
payment in good faith, the carrier would not be liable if it
turns out that the check or money order were counterfeit.
Become a secured creditor by asking the debtor to pledge one
or more assets to the seller, and then perfect the security interest
in the pledged collateral. By definition, a secured creditor
is one that holds the pledge to assets of a debtor that secures
either payment of a debt, or the performance of another obligation.
Purchase credit insurance covering this account. Note: The problem
is that the credit insurance company is likely to have similar
concerns and reservations about insuring the applicant. Also,
remember that credit insurance involves 'risk sharing' between
the insurer and the creditor. Risk sharing includes the use of
annual deductibles, per loss deductibles, accounts excluded from
coverage, a cap on annual losses paid, small dollar loss exclusions,
and exclusions from coverage for disputed balances.
Similarly, it might be possible to sell the receivables from
this new account to a factor...but it seems likely that the factor
would have the same concerns as the creditor and the credit insurance
company about purchasing receivables from a high-risk customer
without recourse. Factoring is the process by which a financial
institution, called a factor, buys accounts receivable from a
business (the client) at a discount and takes in return an assignment
of the accounts receivable. Factoring is done with or without
recourse. Factoring with recourse means that if the factor is
unable to collect from the purchaser/debtor that the seller (the
factor's client) must repay the money advanced to it against
that accounts receivable. Factoring without recourse means that
the factor accepts the risk that the accounts receivable may
Ship merchandise to the customer on consignment. Under consignment
terms, the consignor (the supplier) ships goods to the consignee
(receiver of the goods) to sell. The supplier retains title to
and ownership of the merchandise. The consignee makes payment
to the consignor only when the goods are sold. The creditor should
perfect a security interest in its inventory to reduce risk.
Require one or more personal guarantees to be sign by the business
owners, and/or officers and directors of the company. Guarantors
take responsibility for paying a debt if the company [which is
primarily liable for the debt] fails to pay the creditor. Personal
guarantees are not foolproof, but they do reduce credit risk
- particularly if the creditor can confirm the personal financial
strength of the individual guarantor(s).
Shorten the open account terms and reduce the credit limit assigned.
Example: If a customer requested a $10,000 limit and net 30 day
terms a creditor company could [in theory] sell the same amount
by changing the terms of sale to net 15 days and the credit limit
Consider requiring their customers to pay using a two party
check...a check made payable both to your customer and to your
Discuss a profit sharing arrangement with the applicant. Specifically,
suggest that the applicant be treated similar to the way you
would treat a broker or agent working for your company. Offer
to pay the applicant company a commission on all new sales they
bring to your company...but maintain full control of the credit
risk management and collection process by billing and shipping
and collecting from their customer.
Require partial payment in advance, or on delivery. For example,
require an advance payment sufficient to cover your cost of goods
sold. If the manufacturing costs are pre-paid, the potential
loss on a sale to this type of high-risk applicant reduced significantly.
It is important to remember that these techniques can be used independently
and in some cases in combination. As with every decision made by
the credit department, a number of factors influence the decision
including: the creditor company's tolerance for credit risk; the
profit margin on the sale; the company's market share and competitive
position; its sales and profit targets; the size of the creditor
company's bad debt reserve; its year to date loss history; and the
protection afforded to the creditor company through implementation
of any of the risk mitigation strategies listed above.
Michael C. Dennis has more than 20 years of credit management experience, and
for the last fifteen years, he has been an instructor for CMA Business Credit
Services [California]. He is also the author of "Credit and Collection Handbook" available
Reprinted in the January 2004 Edition of Business