Every factor to be considered prior to an extension of credit is in some way related to risk assessment. Or, to put it another way, before extending credit you should determine how likely or unlikely it is that you think you are going to be paid. When you are able to secure the extension of credit, the likelihood of payment skyrockets, and the extension of credit can be approached in that manner. It’s no secret that secured creditors are put in much better positions to be paid than are general unsecured creditors.
Security & Risk Mitigation in General
Extending labor and/or materials on credit opens up the possibility of your business being burdened with bad debt. There is some risk of nonpayment in every credit situation, but this risk can be mitigated. And, since the actual cost of bad debt is much greater than the amount of the original debt, it clearly makes sense to insulate your business from this type of exposure. While it may not be possible to reduce bad debt to 0, it can come very close, and there are ways to drastically limit potential exposure and to maximize profit – all without resorting to an overly restrictive credit policy.
So, why is securing debt important on construction projects, and how should it be assimilated into your company’s credit policy?
Secured debt is backed by a security interest in collateral. This serves to reduce the risk associated with extending material or work on credit. This means that a secured debt is backed by an ownership right in an asset that may be claimed in the event of a default by an indebted party. A security interest may be voluntary or involuntary, and the specific type used will have an effect on how a credit policy should be structured to take advantage of the benefits of securing debt. A voluntary lien is something that must be agreed to by the parties. This agreement typically occurs as a condition to the extension of credit and therefore should take place prior to the decision on whether to extend credit or not. An example of voluntary security that can be incorporated into a credit policy is a UCC lien. An involuntary lien arises through operation of law, whether or not the indebted party consents (provided the proper steps are taken). An example of this is a mechanics lien.
For many parties in the construction industry, the security instrument that makes the most sense to incorporate into a credit policy is the mechanics lien. This is true for many reasons, not the least of which is the fact that the right to claim a mechanics lien is built directly into the law of every state as long as certain factors and steps are met. However, if the requirements have been complied with, the mechanics lien gives the lienor a right in the actual property improved by the work or materials supplied. This means that if he is not paid, he can foreclose on the property and obtain payment front he property itself.
Use & Non-Use of Security in Construction Industry
With the enormous benefits that can come from securing debts owed for work performed or materials supplied on a construction project, one would assume that the default position of industry participants would be to use the security available to them on all projects. For some reason, this is not the case. In a general sense, it seems like there are two overriding reasons why securing extensions of credit is not necessarily the default position in the construction industry.
The Worry That Using Security Rights Can Damage a Business Relationship
Some businesses choose not to exercise their security rights because they feel like doing so starts a relationship on the wrong foot, or risks alienating their customers – that contemplating non-payment at the beginning of a relationship was awkward at best, and at worst an indictment of the company with whom they are doing business. This is a fairly pervasive belief, and surprisingly, does not seem to be tied to company size. Huge companies succumb to this worry just like smaller companies do.
Is it really the case, that using security will alienate customers?
While it’s not too hard to see where this viewpoint comes from, after all if somebody cannot be trusted to to pay what they owe, why are you doing business with them?, it’s misplaced. The fact of the matter is that businesses have been securing the debts owed to them for a long time. And in most industries in which security is available, it is unfailingly used. And unfailingly expected. Nobody is taken aback when a lender uses the security of a mortgage as a prerequisite for lending money for a home purchase.
Securing debts is obviously beneficial to all businesses that have the option to do so. Since the ability to use security is directly given to parties on construction projects, it is time for the industry to out it to good use. More and more construction companies are beginning to more thoroughly understand how much sense securing debt makes, and new technology has enabled these companies to more fully use it. Because of this, the stigma of requesting security when credit is extended is fading away, if it was even ever actually there to begin with. Most businesses are, at least to some extent, pragmatic, and understand that taking all available precautions just makes business sense.
Is Full Use of Security Too Costly To Be Beneficial?
New advances in technology, have made gaining the benefit of security in the construction industry easier and faster than ever. The laws related to mechanics liens and bond claims are convoluted, and it used to be that deciphering them and acting appropriately was nearly impossible. But, with technology companies providing platforms to manage this process, notice outsourcing, and the rise of electronic filing, the ability to secure the debts owed to construction companies is within grasp, without the need to appoint a full-time employee to handle.
A robust credit management scheme no longer requires the resources, in both money and time, that it used to. New technology has changed the conversation as to whether securing all credit accounts comes out of the proper side of a cost/benefit analysis. Now, the ability to collect a single account that previously would have been written off can be enough to justify securing every extension of credit.
Securing debts just makes good business sense. And, now, technology has broken down the barriers to its widespread use in the construction industry.