By Scott Blakeley, Esq.

Scott Blakeley, Esq.

The following article appeared in the Fall 2011 issue Blakeley & Blakeley's Trade Creditor's Quarterly.

Your company is a sole-source supplier with a multiyear supply contract with a customer who is a significant source of business for your company. You are the sole sole-source supplier because of the uniqueness of your product or service. The supply contract was negotiated by sales and marketing when the customer was financially sound. A year into the contract, the customer's cash flow is negative and they have failed to honor the 30-day invoice terms. They blame a downturn in the economy as to why they cannot pay according to invoices.

The customer has placed additional orders, but needs credit because of cash flow issues. Your credit research and evaluation indicates that the customer's cash flow problems are projected to last but two quarters (and, of course, confirmed by the sale's department) and may remain a significant source of business over the balance of the supply contract. The customer's cash flow problems result in the lender calling the loan in default. Your account is now 45 days past due.

You consider balancing alternatives for improving the quality of the delinquent account through a negotiated repayment agreement, yet working with the sales force to ensure that the customer remains a meaningful source of revenue by honoring the orders. Your company, of course, does not want to lose the significant revenue generated by the customer, but likewise does not want to increase its credit exposure.

The strategies considered below are consistent with conventional credit enhancements, such as letters of credit and deposits, the purpose of which is to reduce credit risk yet make the sale whether the customer is current or delinquent. But the strategies considered below take into account the unique co-dependency trade relationship where a vendor is a sole-source supplier to the customer, and the customer is a source of significant revenues for the vendor. These strategies presuppose a team approach from the vendor: the credit function collaborating with the sales force along with senior management to target a revenue number while managing credit risk.

The Sole-Source Supplier: What Makes You Unique

If the vendor has a unique product or service, such as a patent, for example, or a unique competitive position, such as a plant in close proximity to the customer, the vendor may be in a position to command a long-term supply or outputs contract. The downside for the vendor is that the customer's significant source of revenue can create a co-dependent relationship that may unwittingly ratchet up the credit risk.

Changing Up the Trade Relationship

From Vendor to Lender: to retain the significant source of business, the vendor may consider a short-term loan to assist the customer's cash flow. Creditor status gives the vendor priority in the event the customer fails to repay, as opposed to investing in the customer.

The tension with this strategy is the customer's capital structure. The customer likely has a preexisting lender which holds a security interest in all of the customer's assets. This lender likely has a say with any financing, even though the vendor would be junior to its secured liens. The vendor may negotiate a secured position, but that security is second to the existing lender.

From Vendor to Investor: the customer solicits your company to invest in it to continue to operate during the short-term downturn.

The tension with this strategy is the risk that the equity investment is lost because of the customer's deteriorating financial position. The equity investment is last in line as to right for payment.

The guarantee may calm suppliers and allow the customer to continue to operate.

From Vendor to Guarantor: the vendor may consider serving as a guarantor for certain of the customer's debts.

The upside for the vendor is that it may not require them to make an immediate infusion of cash.

However, the risk is that the vendor may be called on to pay on the guarantee if the customer fails to pay the guaranteed debts. The vendor guaranty is to encourage the customer's suppliers to continue to provide trade credit, thereby stabilizing cash flow. The guarantee may calm suppliers and allow the customer to continue to operate.

From Vendor to Working with the Customer's Lender: the customer's lender has a security interest in all of the customer's assets including accounts receivable, inventory and cash. The vendor may be able to calm the lender's anxiety with the customer's financial performance by committing to guarantee certain of the customer's accounts receivable, or guarantee a floor for the lender's collateral should it be forced to foreclose on the customer.

The tension with this strategy is the amount the vendor must guarantee compared with the value of the trade relationship.

From Vendor to Third Party Guarantees: the vendor may insist that the owner of the customer (if a closely held company) provide a personal guarantee to the vendor to protect it for its trade credit or financing. The guaranty creates a contract of secondary liability. The customer's owner may provide the guarantee to the vendor given the alternative that the customer's lender may foreclose on the business. Likewise, the customer may have an affiliate business with value that may furnish a guarantee to the vendor.

The tension with this strategy is that owners are resistant to furnish personal guarantees if they have personal net worth.

From Vendor to Owner: in certain situations, the vendor may determine that the economics are such that buying the customer may be the most effective way to maximize the value of the relationship. This is the ultimate equity investment.

The vendor must be vigilant with its approach to financially assist the customer in a sole-source trade relationship. The opportunities that the strategies discussed may present to the vendor are preserving the trade relationship and the sizeable revenues. The downside with the strategy may be the vendor increasing its credit or investment exposure. Further, a vendor may find that too close a trade relationship with the vendor may open the door to be labeled an insider under the Bankruptcy Code which may extend the preference exposure from 90 days to one year, should the customer file bankruptcy.

Contact info
Scott practices creditors' rights and bankruptcy law. His e-mail is seb@blakeleyllp.com.