Almost every small business will have to deal with bad debt at some point. Ensure that you manage that risk effectively with these 7 tips from a litigation lawyer.
If you run a business then the chances are that you have had to deal with clients / customers who refuse to pay, and the subsequent bad debt.
Some businesses are more susceptible to bad debt than others, but bad debt has a direct impact on the cashflow of all businesses, and in some industries (building and construction for example) it may be the difference between staying afloat or going under.
This article will give you 7 tips to reduce bad debt, and/or make the recovery of that debt less difficult.
Tip 1 – Know who your customer is
This may sound silly, but it is important to know the correct entity of your customer.
Do some due diligence, for example are they a sole trader, a partnership, a company, a trading trust?
Search the business name register to see who the actual owner of the business name is.
If they are a company then buy an ASIC company extract (they’re $9) to see the company structure, directors, and shareholders.
If the client/customer is a trading trust ask them for details of the trustee, as it is the trustee that is the trading entity and not the trust.
Once you have identified the correct entity, then you can add that entity to your contract.
Tip 2 – Do a credit check
You should also perform a credit check as part of a risk assessment.
A credit check is a way to ascertain the creditworthiness of a company, a person, or a director of a company.
You can order a personal credit report, a company & director report, or a company credit report.
You can then gauge the type and level of credit you want to extend to that client/customer.
Tip 3 – Ask for trade references
You should ask for at lease three (3) trade references.
A trade reference is the name and contact details of businesses that the client/customer has worked with previously and offered credit terms.
Then, actually call the trade references and ask your risk assessment questions.
The Credit Contract
If you have done your due diligence on the prospective customer/client above, and you agree to enter into a credit agreement with them, then there are some vital clauses that you should have in your contract.
Tip 4 – Include a PPSA charging clause
The Personal Property Securities Act 2009 (“PPSA”) allows you to charge the personal property of the entity you contracted with.
A properly drafted PPSA clause grants you a security interest in an asset, or the assets of the client/customer.
If you offer goods on credit, then you can charge those goods until payment is made in full. This also allows you to seize the goods if the client/customer defaults on payment.
This also raises you to the status of a secured creditor if the client/customer becomes insolvent.
Tip 5 – Include a director’s or personal guarantee clause
If you are trading with a company then it is the company that is the contracting entity, with limited liability of its members and shareholders. This is called the corporate veil.
You should include a clause in your contract which makes the director (or directors) of the company personally liable for the debts of the company.
Tip 6 – Include a charging clause
This might me a bit of a serious clause to add, so care should be taken before adding it to your credit contract as it might scare a prospective client off.
A charging clause, similar to a PPSA clause, charges the real property of the client/customer.
This means a charge over their house or land, allowing you to lodge a caveat as security for the debt.
Obviously, taking someone’s house, or threatening to do so, is a very serious thing which might have long-lasting effects on your relationship with that client/customer.
However, it is also great leverage in a negotiation to get you paid, and again raises you to the level of a secured creditor in the event of insolvency.
Tip 7 – Include good default clauses
Having clauses in your contract which deal with a default are vitally important in recovering your debts.
You should include clauses which allow you to recover the following items:
- Debt collection and legal costs on an indemnity basis;
- Default interest on all unpaid money; and
- Liquidated damages clause.
Debt Collection and Legal Costs on an Indemnity Basis
You should have a clause which allows you to recover debt collection and legal costs in the event of a default.
This will allow you to recover a lot more of your expenses from the debtor in the event of a default.
Default Interest on all Unpaid Money
You should also have a clause in your contract which defines a rate of interest on all unpaid monies in the event of default.
This will attempt to recover an amount of money that that debt would have made had it been paid on time.
Liquidated Damages Clause
If applicable, a liquidated damages clause is a genuine pre-estimate of damages that you will incur in the event of default. This could be $50 per day, for example.
This clause attempts to put you in the position you would have been in but for the default.
Firstly, do your due diligence to ensure that you are managing the risk effectively.
Secondly, in the event of a default you should have clauses in your contract which allow you to recover the maximum amount possible, in the shortest amount of time.
This post was written by Wayne Davis , Legal Practice Director (LLB) at Stonegate Legal.