Credit policies is a set of guidelines that
1) are used to determine which customers are extended credit and billed;
2) set the payment terms for parties to whom credit is extended;
3) define the limits to be set on outstanding credit accounts; and
4) outline the steps or procedures used to deal with delinquent accounts. When it’s broken down into its component parts, a credit policy seems to be an encapsulation of how risk averse a company is vis-a-vis extensions of credit and other monetary policies with respect to accounts receivable.
Part 1: Creating The Policy’s Structure
The credit policies must at first contain some structure. This structure will dictate the company’s overall mission and approach to the credit management role in the organization, and it will ultimately organize all of the credit customers into categories so that the associated risk can be well understood and property managed.
#1) The Credit Department’s Mission Statement
Mission statements are easily overlooked, but nevertheless, can prove to be one of the most important aspects of a credit policy. Just like a corporation’s mission statement can and should be referred to whenever confronted by any difficult decision, this same functionality can be served by a credit department’s mission statement. The best credit policies will not be able to address every possible situation and variable, but a refined mission statement can help guide credit managers and other team members on any situation and decision.
As Nate Budde succinctly put it in the article Crafting a Credit Department Mission Statement, “by deciding to operate within the purview of Mission Statement, the credit department has a ready-made guide” to any situation that arises.
You may want to spend more time on crafting your department’s mission statement than you do on the remainder of the policy. Think about things such as:
- Your company’s overall goals, and how the credit department relates to these goals
- The company’s unique position in the market
- The company’s mindset. Is it aggressively focused on growth, or profit?
- Structure of the department and autonomy provided to team members
#2) The Credit Application Process
The credit application process represents the entry-point for a company’s credit relationship with their customer. A company’s credit policy will not have any applicability until the company somehow extends credit, and the company is not going to extend credit until someone, somehow, asks for or is provided the credit.
The “credit application process” refers to the process employed by the company that leads to the extension of trade credit to another organization. Typically, this occurs when a company fills out an application for credit with another company, but this is not necessary in every case. In the construction industry, for example, the “credit application process” manifests itself in one of two ways:
(1) For many subcontractors and trade contractors, they decide to extend credit when they make a bid on a project or decide to work on a job; or
(2) For most suppliers and equipment rental companies, they require companies to formally apply for credit through a credit application.
In either circumstances, companies should be thoughtful about what information they require to make a decision about whether to extend the credit, and then disciplined to collect, verify, and maintain that information.
Meredith Wood of Funding | Gates wrote a great article that enumerates some of this important informant in Creating A Concrete Credit Application, whereby she set forth the following information items:
- Contact Information
- Credit Information
- Landlord and Mortgage Holder References
- Bank and Trade References
- Statement of Payment Terms
- Personal Guarantee and Signature
#3) How You Will Segment Your Risk Categories
Every organization that receives trade credit from you will be different. Every B2B credit relationship has different shades of nuance, and this must manifest itself in the credit policy through the definition of different risk categories.
Those extending credit must get very comfortable with their financial risk tolerances. After all, every dollar of credit extended presents at least some degree of risk. Some companies will be comfortable taking very aggressive risks to improve their top line, but other companies will be more conservative and want to only take safe risks. Most companies will take a mixture of aggressive and conservative risks, couple them with different protective devices (many explained below), and apply different credit management techniques to each.
Success in managing different risk types starts with clearly identifying these different risk categories. The credit policy should contain clear, straight-forward risk buckets, such that any credit department team member can clearly and quantitatively place a customer into one of the categories, and thereafter understand exactly how to manage that customer’s credit relationship with the company.
It’s important to keep this simple. It’s easy to gravitate towards creating complexity with the risk categories as you’ll start to consider different variables and want to address them all. Getting too specific and address every variable, however, will defeat the purpose of the policy and will leave your team with too much complexity and a degree of decision paralysis. Push yourself to swim upstream on the variables and separate the risk categories at a very high level.
Part 2: Establishing The Tools To Manage The Company’s Risk
With the high-level risk categories in place, you will now be ready to tackle the details of the company’s credit policy. You now have the overall mission statement written, and a process to accumulate data about potential customers and their associated risk. Now, with risk categories, you can take that data and categorize the customer.
#4) Personal Guarantees
The personal guarantee is popularly used to bridge the credit gap with business customers that do not have a sufficient credit record to justify a line. It’s common for small and medium businesses to lack a reliable credit record. In fact, these companies are frequently referred to as the “Fortune 5 Million,” and they don’t fit into the nation’s credit data schema. Consider this great “Open Letter to the Fortune 5 Million” written by Able Lending.
A personal guarantee is just what it sounds like, a personal commitment by the guarantor (usually the business owner, or the person signing the contract for credit) to pay any debt incurred under the credit agreement personally in his/her individual capacity if the business defaults on the debt.
The larger and more established a business, the more difficult it will be to get a personal guarantee from them. However, this balances itself fairly well because the need for personal guarantees decrease based on the size and establishment of a business. While personal guarantees are nice-to-haves, they have limited utility and they are only as valuable as the credit worthiness of the individual signing it.
There is a great discussion of the pros and cons of personal guarantees, as well as sample personal guarantee contract language, in the article: Personal Guarantees in the Construction Industry.
For those extending credit in the construction industry, personal guarantees can be a nice add-on to protections afforded by mechanics liens, joint check agreements, UCC security interests, and the like. However, they generally should not be relied upon in lieu of these more powerful and less-intrusive protections.
#5) Joint Check Agreements
Joint check agreements — also commonly referred to as multi-party checks — are common in the construction industry because there are so many tiers of parties involved in the construction payment process. The basic definition of these agreements is a contractual agreement between multiple parties whereby one party agrees to or is given permission to make payment jointly to two or more parties.
Anyone familiar with the construction industry can see how these may likely be used, and anyone in the industry has likely used the document on numerous occasion. Though popular with construction project participants there is nothing in the law limiting this tool to that industry. In fact, there is nothing in the law about the instrument at all. One of the most surprising (and dangerous) things about joint check agreements is that they are not regulated by statutes in any way…the tool is simply a contract between three parties. The contract can say whatever the parties want it to say. In fact, they frequently say all kinds of crazy things!
As explained in the article, “What is a Joint Check Agreement,” there is “no such thing as a standard joint check agreement.” This has practical consequences for those trying manage such agreements because:
The parties to a joint check agreement can write the agreement any way they want. While this sounds nice and flexible, the result is that the industry is flooded with a ton of sample joint check agreements, and each of the samples would have sometimes significantly different effect.
The credit policy, therefore, needs to set forth when a joint check agreement is desired and when it can be used to possibly offset a businesses’ potential credit problems. The credit policy, however, must go further than this and get detailed bout the form of the joint check agreement. Credit department team members will need clear guidance on what exact joint check agreement forms are acceptable.
We wrote an entire blog series on Joint Check Agreements which explored the form problem as well as a host of other problems and situations that arise with joint check agreements. These situations include topics like the controversial “joint check rule,” and joint check fraud. Dig into this topic in more detail here: The Complete Guide to Joint Checks.
#6) Preliminary Notices, Mechanics Lien Rights, and other Security
Joint check agreements can be useful, and personal guarantees are nice-to-haves, but by far, the use of security rights are the most important and effective credit management tool for credit departments. Just as a bank uses collateral and security interests to offset the risk of every loan, any company issuing credit can claim “security” on certain things to offset their credit risk.
The difference between a credit mitigation tool like the joint check agreements and security rights is nicely compared in this article: Joint Check Agreements v. Mechanic Liens: Comparing the Tools. It includes this phrase, which is applicable to almost every other non-security rights tool: “When you file a mechanics lien claim you are actually staking a claim in the project itself,” which acts as collateral and nearly guarantees payment of the debt.
There are a variety of different security rights available to credit departments.
Those outside of the construction industry will commonly rely on UCC (Uniform Commercial Code) right. Filing a UCC lien enables companies to claim rights against movable property, receivables, and other assets, in the event of non-payment. The lien must be given to the credit department through agreement, and a “financing statement” must be filed at the time credit is given. This is common outside of the construction industry, but usually not applicable to those furnishing labor or materials to a construction job. For more info on UCC rights, see this article: Credit Policy: Using UCC Financing Statements to Secure Your Extensions of Credit.
Those in the construction industry are typically not eligible to use UCC rights. Instead, they have mechanics lien and bond claim rights. To utilize these rights, those furnishing labor or materials to the construction project must analyze and protect their rights at the start of a project. This usually requires delivery of a preliminary notice, and then the monitoring of the lien window as the project (and account) ages. To understand the mechanics lien and bond claim compliance process, consider zlien’s methodology to protect and use these rights, as illustrated in the below graphic:
Part 3: The Procedures That Tie It All Together
And in part 1 addressed the structure of the credit policy as a whole. Part 2 addressed some specific tools available to credit departments to mitigate and manage their credit risk. This Part 3 will tie all these items together, discussing the specific policies and procedures that are built using the Part 1 structure and the Part 2 tools.
#7) The Lien Policy (including Lien Waiver Management)
The use of security rights are available to credit departments to offset their credit risk. For those involved with the construction industry, this refers to the use of mechanics lien and bond claim rights; and the use of these rights necessarily requires credit departments to understand and manage preliminary notices (to protect their rights) and lien waivers (to manage the payment process). All of these components are described within the company’s overall credit policy through some sort of “lien policy.”
In the construction industry, a well-done lien policy can have a substantial impact on the top and bottom line. The bottom line can be improved because security rights will limit losses, aged receivables, and bad debt. The top line can be improved because security rights enables companies to extend more credit and take more business. In fact, it’s clear that checking company credit worthiness may be irrelevant and unnecessary with a strong lien policy.
The lien policy is simply an overview of what procedures your company will follow to preserve, perfect and enforce its mechanic lien rights. The following are some elements of a lien policy as set forth in our Guide to Creating a Mechanics Lien Policy:
- Set forth a Commitment to Sending Preliminary Notices
- Outline a plan for execution to accurately send & track notices
- Monitor lien deadlines
- Establish a reliable, fast, and available method to file lien and bond claim documents
Another, often overlooked, component of a lien policy is the method of handling the lien waiver process. Lien waivers are dealt with on nearly every construction project, as contractors, lenders, and developers, require signed lien waivers before making any payments. The topic is a huge one, though, as these documents can be complicated. Creating a great lien policy will require an understanding in the perils of lien waiver mismanagement, and establishing clear directions for team members to handle lien waiver requests. A good place to get started is with this article: Is Everything You Know About Lien Waivers Wrong?
#8) The Collections Policy: Contemplating The Payment Funnel
Inexperienced credit policy drafters will gravitate immediately to the “collections policy,” and start setting forth all the ways to collect on a debt. It’s natural to focus here since the credit department’s ultimate job is to collect cash, but it’s a mistake to over-focus on the collection practices. The actions taken to collect on an account is just one aspect of the credit policy as a whole, thus justifying its inclusion in this list at #8.
Nevertheless, the collections policy is not be overlooked.
Simply stated, a collections policy is the set of procedures a company uses to ensure payment of overdue accounts receivable, after securing the debt, and before litigation. Generally, a collections policy systemizers the steps taken to recover amounts due prior to the initiation of litigation, if that step is required. These processes include when a customer should be contacted, how they should be contacted, how disputes are resolved, when internal or external “collectors” are used to step-up collection efforts, and ultimately when and whether to turn the account over to litigation or write-off the debt.
Another way to think about the “systemization of the steps taken to recover amounts due” is as a “payment funnel.” We explored the concept of the payment funnel here: The Payment Funnel: A Step-by-Step Guide to Overhauling A/R. As stated in that article:
A payment funnel is a defined and repeatable set of steps designed to get construction companies paid on every project. Every project goes into the funnel at the top, and through each progressive step the number of non-paying accounts decreases until, at the bottom, the number of projects remaining unpaid is negligible, and the A/R report looks sparkling. The “secret” trick is that companies in the construction industry are able to create a strong payment funnel by leveraging mechanics lien and bond claim rights – security is built right into the law.
The payment funnel is another, perhaps more practical way to think about a collections policy. Savvy drafters of a collections policy would think about it in the context of creating a payment funnel.
#9) Litigation Policy and Procedures
As above stated, the collections policies and payment funnel are the steps a company will take to collect a debt after it becomes due and “before litigation.” Unfortunately, however, some accounts will go into a severe default state and will require more aggressive action. While security and mechanics lien rights will help companies avoid much litigation, there is no way to avoid all litigation forever, and accordingly, a solid credit policy must also contemplate the procedures and practices to employ when confronted by litigation.
We addressed this topic in the following article: Drafting a Written Litigation Policy is Good For Business. This article stated that drafters should consider the following factors:
- Understand that litigation policies are not “one-size-fits all” products
- Refer to the credit department’s mission in thinking about litigation temperament
- Consider variances of risk categories to guide litigation decisions
- Empower managers to make specialized and ad-hoc decisions
- Contemplate when in-house counsel can be used, v. hired counsel
- Research potential attorneys so you’re ready to hire when a situation arises
#10) Managing and Oversight
The first 9 credit policy considerations all related to the credit policy itself, but this final consideration contemplates how the credit policy will be managed and supervised. As any great manager knows team managers “respect what is checked.” The attention that a manager pays to certain elements of a company’s procedures just naturally highlights what is considered important by the manager and the company.
Successful credit policies create clarity around structure, mission, risk categories, and procedures…but they also create clarity around how the team will actually execute on and manage to the policy. Accordingly, build in team responsibilities and roles, and how the policy will be managed, supervised, and perhaps even how compensation will be impacted based on successful collection failures that follow policy versus those that do not.
Credit and collections management is crucial to a company’s working capital situation. And ultimately, how a company can grow and be successful. These policies require a lot of thought and planning, and they must address a variety of important elements. Those drafting these policies should start at the top by crafting a true mission. And finish by specifically thinking about the execution and management of the policy. These 10 considerations should be referred to as build a comprehensive credit policy.