Driving to work this morning I was thinking about my aging receivables and was becoming increasingly frustrated. Although I am a lawyer and work in a Philadelphia law firm, I am also, at my core, the owner of a small business. I provide services and expect or hope to get paid. My situation isn’t very different from any business or service provider. As I thought about what I could do better to insure that I got paid, I thought there are probably a lot of other business owners, chief financial officers and the like that would appreciate options they can consider implementing to increase their chances of being paid for services rendered, products delivered or items that were manufactured.
The starting point – your contract. Whenever a client or potential client calls me and wants to discuss how to structure a transaction to insure they are paid or at the very least minimize the risk they are not paid the starting point is always the same. Have you worked with this entity before and do you have any written agreements or standard terms and conditions that govern the contemplated transaction? Every contract starts with the assumption that each party will be responsible for paying its own legal fees? This concept is known as the American Rule. However, if your contract or standard terms and conditions state that the buyer will be responsible for all costs and expenses, including legal fees incurred in connection with your collection efforts – you have successfully shifted the American Rule on its head. Now, not only is the breaching company responsible for paying your outstanding receivable, but it is now responsible for your legal fees as well. Keep in mind that this does not necessarily guaranty payment but you not have another hammer in your negotiation arsenal to use against the defaulting party.
Cash is king. In my line of work the only way I can completely guarantee payment is with the retainer. Similarly the simplest way to guarantee payment is cash up front before services begin. This is why, for example, doctors require the co-payment before services are rendered and not on the way out. However, recognizing this is stating the obvious, other possibilities include timing the payments better. For example, if you are manufacturing a specific part for a customer or providing consulting services, develop a payment schedule that is tied to verifiable deliverables. If you meet a deliverable milestone and they don’t pay, you stop working. Other possibilities that can be explored is cash on delivery (COD). COD is a very basic but effective method to insure that you are paid when a physical product is involved.
The guaranty. When dealing with a financially troubled company it is always a good idea to explore the idea of another person or entity guaranty the payment. In this scenario there will always be push back from the company but it always comes down to negotiating power. Who needs whom more? While I always try to get a retainer, when I represent a company like Sprint or PNC Bank for example, they don’t give retainers. If I want to work with these entities, I have to work under their standard terms. If you are able to get guaranty from a third party, it is important to make sure the guaranty allows the collection process to start when there is a default and does not require that all options available have been taken against the debtor company first. In other words, an effective guaranty will allow simultaneous enforcement against both the guarantor and the debtor company.
The Letter of Credit. Related to the idea of a guaranty is the letter of credit. In this situation, your company has manufactured a product and if the vendor does not pay, you are able to draw against the letter of credit. In other words, the bank pays you what your vendor should have paid and then the bank will go against your vendor for payment.
The Security Interest. When a bank lends money to a borrower who want to buy real estate (commercial or residential) it will always ask for a collateral. If the borrower is unable to pay, the bank makes sure that it can take back the property you purchased with the money the bank advanced. This is accomplished with a security agreement. In the case of real estate, this is the mortgage. If you fail to live up to the terms of the promissory note, the bank will enforce its rights under the mortgage and take back the real estate.
If you are a financing company, this scenario is accomplished through a security agreement and UCC financing statement. The security agreement will govern the terms and conditions you can take back the object financed if payment is not made. The UCC-1 financing statement is necessary to protect you so an unscrupulous debtor is unable to take the equipment that it financed with you and offer it as security for another line of credit. Without the UCC-1 you will be unprotected and a third party might be able to have a claim above you with respect to the very object your financing allowed the debtor to purchase. Think of the financing statement as a public notice system where you can look to see if the item you are consider as collateral is subject to claims by third parties. If you don’t look into this, the risk falls on you.
Consignment. Consignment is an arrangement where you retain title to the product until the seller is able to sell it to a third party. If this is done correctly, you get the product back if it is not sold. The danger here is that the product is not in your possession during the entire process so you lose control. Further complicating this is if the legal requirements are not strictly complied with, the seller’s bank might get priority over your consigned property.
The Setoff. This isn’t so much a way to structure a transaction as a concept to be included in your agreement. This is why it wasn’t placed in the “contract” section at the start of this post. As the provider of good and services, you want to retain the right to set-off while not allowing your customer this right. Consider this example. You deliver commercial lawn equipment to a commercial developer and it agrees to pay $100,000 for the equipment. Unfortunately the developer asserts that 5 machines are damages and as a result you owe him $20,000 for the value of the damaged machines. If the developer has not paid the $100,000 for the machines, you can find yourself in the untenable position of owing the developer $20,000 while the developer owes you $100,000 as opposed to the developer just owing you $80,000 thru an offset.
As set forth above, the purpose of this post was to make you think about what can I be doing to maximize the probability that I get paid for the services or products that I deliver. These are just a few of the basic ideas. There are other concepts, a stock pledge, for example, that can be used depending on the situation and the players and history involved. Every situation is uniquely different and needs to be carefully considered in the context of the business history between the parties. Should you wish to discuss any aspect of this post, please feel free to contact Doug Leavitt at Danziger, Shapiro & Leavitt, P.C.
This entry is presented for informational purposes only and does not constitute legal advice.