The Art of the Restart
This is the first in a series of alerts that will provide guidance on various topics related to business continuity and strategy.
Topic of this alert: Financial planning – managing the creditor and debtor relationship
Managing the Creditor and Debtor Relationship
Managing the pre-opening period as well as the period post-opening will require careful strategic planning. Unlike starting a company, where operational and payroll costs are typically low and enterprise value is negligible, re-starting a company that has been a going concern requires management of substantial overhead and preservation of equity value. While most companies by now have addressed their payroll costs during the past few weeks of shut-down or reduced operations, they have yet to feel the fully address the creditor-debtor relationship.
Basic Types of Credit
In a prior post [click here] we outlined the relationship and relative rights of landlords and tenants. This posting will focus on three categories of creditor/debtor relationships:
- Unsecured obligations
- Secured obligations
- Obligations with personal guarantees (which can include either unsecured or secured obligations)
What is it: An unsecured obligation is an obligation owed to a third party that is not backstopped by any specific assets of the business. In the event of default, the creditor does not have a right to satisfy its balance due from any particular business asset and is generally subordinated to any secured creditors (typically a bank).
Who is it: In general, unsecured obligations tend to be trade creditors (companies that provide products or services in the ordinary course of business to other companies). These obligations are typically reflected in accounts payable on the company’s balance sheet and reflect the liabilities that tend to be related to the operation of the business on an ongoing basis.
What is it: A secured obligation is an obligation that is owed to a third party and is collateralized by specific assets. In the event of default, the remedy of the creditor includes the right to seize the collateral if the obligation is not paid by the borrower. If the balance remaining on the financing exceeds the value of the collateral, the borrower remains liable for the balance. The secured creditor is otherwise treated as an unsecured creditor – in simple terms, no right to any other specific asset of the business.
Who is it: In general, this will be obligations to a bank that extended credit, or purchase money financing (e.g. financing on a piece of equipment).
What is it: Either a secured or unsecured obligation that (typically) the owner(s) is personally liable to pay in the event the business defaults on the loan. The biggest misconception that guarantors have is that a creditor must first try to collect a balance due from the company before they can sue the guarantor. Most guarantees are guarantees of payment, not collection. That means that once the business has defaulted, it triggers the guarantee and the creditor can sue both the company and the guarantor.
Who is it: Typical obligations that are personally guaranteed: corporate credit cards, bank loans, certain types of trade credit (for instance, material suppliers in the construction industry). Note that credit cards often catch owners by surprise – the fine print is almost always that the signor is personally guaranteeing the payment to the credit card company.
Managing the Relationship
There are several basic factors that determine who controls the creditor/borrower relationship and the motivation of the parties to compromise (there are others but these are the typical primary factors):
- Risk of loss
- Value of relationship
- Available remedies
Risk of Loss
The party that bears the lower risk of loss in the relationship will often, above all, dictate the relationship and be in the better position to negotiate a compromise. A fully secured and personally guaranteed obligation has a relatively low risk of loss for the creditor vs. an unsecured, non-guaranteed general trade creditor that will have a relatively higher risk of loss. Thus, the first step to a negotiation is determining which party has the higher risk in the relationship and then using that risk to allocate negotiating strength. It should be relatively obvious that a borrower will have little ability to negotiate with its bank on a fully secured line of credit that is backed by a lien on the business accounts receivable, and a borrower that owes a trade creditor a relatively small amount of money will be in a stronger position to negotiate payment terms or a discount.
Value of Relationship
Offsetting the relative strength of a party in a risk of loss negotiation is whether the relationship is valuable to one or both of the parties. A business might be in a position to negotiate payment terms or a discount on a balance due with a trade creditor if the risk of loss to the trade creditor is higher than the financial impact to the business, but if the business depends on the creditor (e.g. a key supplier), then the risk to the business operations can offset the risk of loss. Example: a vendor that is the sole source of a highly specialized good or service to a business can refuse to continue providing services if it does not reach an appropriate resolution on its accounts receivable.
The ease of ability and likelihood of success for a creditor to enforce its rights is the final factor. Despite that a creditor may otherwise have the upper hand, if its available legal remedies are not practical or time consuming to enforce, then it will be forced to compromise. Legal actions are time consuming and expensive (and during the pendency of a lawsuit the financial circumstances of a party can change), and even once a remedy is obtained (e.g. a judgment in favor of the creditor), actually collecting payment is often difficult. The overall length of time that legal actions take can be a disincentive to enforce rights, especially if the creditor wants payment now.
Moreover, often the remedy that the creditor has available is impractical. A creditor that is secured by equipment does not typically want its equipment back – it wants payment. Thus, if forced to elect its remedies, it may find itself obtaining an outcome that is counter to its objective.
Knowing your rights and determining your relative bargaining strength has a significant effect on the ultimate outcome in the negotiation of a compromise between creditors and borrowers.