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Credit risk: a few easy steps can prevent major headaches, even extinction

Entrepreneurs are constantly setting up companies as new business opportunities arise. It’s called innovation, and that’s what Silicon Valley is all about. VCs put their money into these companies to help them grow with the expectation that they will make a great return on investment themselves—and they perform significant due diligence and risk assessment before investing.

So it always surprises me when many of these innovative companies that have been assessed for investment risk by their backers act cavalier when it comes to managing the financial risks within their fledgling businesses. Even more surprising is that many of the venture funds that have invested their money never question the company’s approach to financial risk management.

Many companies, particularly start-ups, sell on terms without checking out their customers for credit risk or taking steps to reduce risk. They are so intent on making the sale to show they have a real business (maybe even desperate) that the quality of the sale doesn’t matter. Many have been burnt when they don’t get paid, and others have gone out of business.

Make sure a customer’s credit is good

All of this is avoidable with a few basic steps—and the most basic of all is to check the credit worthiness of a new customer. It takes a minimal amount of time to do, yet in many cases it’s seen as an unnecessary hassle. (This is rarely a problem in public companies, as a basic SOX control on revenue recognition is a requirement to assess collectability. That is one area where SOX has added a lot of value.)

If it is not possible to establish a customer’s credit competence, get them to prepay, use a credit card or provide some sort of guaranteed financial instrument. I have rarely seen a sale cancelled because appropriate terms cannot be agreed upon, yet I have seen companies suffer a lot of pain when they realize, too late, that they have made a poor sale. It’s not only the loss of the receivable that hurts. The cost in time, effort and third-party services to chase the money can be exorbitant, too.

Make sure that credit stays good—and take basic precautions

In addition, companies need to reassess credit terms on a regular basis. Often I see companies check out credit risk and give terms for an initial sale, but they never reassess the customer’s credit risk thereafter, not even when the customer deviates from the agreed terms on that sale or a subsequent sale. Sooner or later that approach comes back to haunt them.

The same is true of credit concentration. Having most of your eggs in one basket is not a good idea, yet many companies do it. Whenever possible, take basic precautions to limit credit concentration, such as selling through multiple channels, or enforcing and continually reassessing credit limits on larger accounts.

Companies that sell overseas also take on significant risk with currency exposure when they sell on inappropriate terms or when the currency risk is not hedged properly. Given the constant headlines about the euro crisis and the considerable downside risk with little upside potential, why do so few companies spend no time considering and minimizing their risk? Beats me.

What I do know is that a small amount of time invested in managing credit and currency risk can save a lot of headaches down the road. It could mean the difference between being in business and becoming extinct.

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