What you need to know to create a smart trade policy.
We attended the MJBIZ show in Las Vegas last fall and were fortunate to speak with many companies that operate in virtually every aspect of the emerging cannabis market. The one thing they all hoped for, and felt confident that would happen, is that the banking system will become available to the industry sooner rather than later.
When that happens, business in the cannabis market is going to change dramatically. Access to the banking system means access to trade credit. When trade credit becomes available to growers, manufacturers, wholesalers, distributors and retailers serving the cannabis market, things are going to change. At every level, the industry is going to have to learn how to provide and deal with managing trade credit and its inherent risk.
What is trade credit? Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. The system commonly is used by business organizations as a source of short-term financing. It is granted to customers who have a reasonable amount of financial standing and goodwill.
Many of the growers and manufacturers we spoke to at MJBIZ, specifically those operating in the Colorado market, already have bank accounts and are extending limited amounts of credit. They accept checks (a form of credit) from their customers, and in many instances, they give customers up to fifteen days to pay their bill. These companies, as well as leading cannabis entrepreneurs, all agree: As the cannabis market matures, the business is going to change. In fact, whether you recognize it or not, you already use some type of trade credit to operate. Your rent is due monthly, your utilities are due monthly, etc. You are extended credit on a limited basis to operate and grow your business.
More and more states are passing laws legalizing medical and recreational cannabis use and companies entering the industry are going to want to access the credit markets and use this money to fuel their expansion. A true trade credit system, at every level of the industry, will need to come into existence. Mainstream corporate America operates in this environment and the cannabis industry will as well. It’s just a matter of time. The financial underpinning that guides the nascent cannabis market today will have to develop to meet the industry’s growth needs. The way cannabis companies transact business is going to change, for the positive, and trade credit will fuel its growth.
Federal regulations force most companies operating in the cannabis space today to deal primarily in cash. If you look back at emerging industries, operating only in cash doesn’t foster an environment for growth. Think of it this way: In a cash environment, a company with $1,000 in cash can buy only $1,000 worth of goods, but in a trade credit environment a company with $1,000 in cash and $2,000 in trade credit can buy $3,000 worth of goods. Potential income from retail sales has tripled.
So, for the cannabis market to grow, it cannot be a cash-only business. Without a doubt, the banking industry is on the side of the cannabis industry. Banks do not make money from cash businesses. They want a part of the billion-dollar cannabis market, and they will exert formidable pressure on federal lawmakers to reclassify marijuana as a legal substance, at least under medical supervision. Currently, nearly 300 banks offer services to cannabis-based businesses, but eventually the entire banking industry—more than 5,000 commercial U.S. banks—will join them. The question is, what must businesses do to implement a trade-credit model that fosters sustainable growth? It is imperative that companies understand how to create and implement smart trade credit policies.
Companies that operate in the cannabis industry will migrate toward a trade credit environment in which a grower grants credit—with terms specifying three days to thirty or more days—to the manufacturer, wholesaler, or distributor, who then grants credit to the downstream entity that sells its products to dispensaries, who retail the products to consumers. Or, a grower grants credit directly to a retailer. Growers, in turn, will be extended credit by their suppliers: lighting companies, soil providers, packaging providers, etc.
Once a company extends credit, it will need to manage accounts receivable.
What is accounts receivable?
“Accounts receivable” refers to the outstanding invoices a company has or the money the company is owed by the customers to whom it has extended credit. Essentially, accounts receivable represents the default risk borne by cash-only businesses. Accounts receivable must be collected on a timely basis, and some number of customers will not pay when their invoices are due. To operate in a trade credit environment, cannabis market companies need to understand:
- Why they need trade credit and what its value is.
- How to establish a trade credit evaluation policy that adequately controls risk.
- How to manage customer relationships and collect accounts receivables on a timely basis.
- What to do if a customer becomes delinquent or refuses to pay.
Establishing trade credit policy
In a mature industry, when a new customer wants to buy products or services on credit, the seller goes through a specific process to determine whether they want to extend credit and if so, how much. To help in deciding, they may request the customer complete a credit application and review and confirm the information it contains, pull a credit report, review banking information, speak with other companies about their experience with the customer, and/or request audited financial statements.
“A true trade credit system, at every level of the industry, will need to come into existence. Mainstream corporate America operates in this environment and the cannabis industry will as well.”
In the cannabis industry, widespread credit granting has not been the norm, and historical credit-related data on cannabis customers is sparse. Therefore, when the ability to provide credit becomes available, most customers will have no prior credit background or history.
Each credit grantor within the industry will need to develop a credit policy that allows the company to meet its financial goals while limiting risk. Per the Credit Research Foundation, a credit policy, no matter the industry, must address the following questions:
- What is the company’s mission?
- What are the company’s goals?
- Who in the company has specific credit responsibilities?
- How will credit be evaluated?
- What are the company’s terms of sale?
- How will the company handle collections?
A credit policy should also be in writing, and it should be reviewed and modified as conditions change.
What is the company’s mission?
The mission statement can focus on many different areas depending upon management’s
main concerns with granting trade credit. Remember, the area of the company most affected by the credit policy is sales. So, defining the level of credit risk you are willing to accept is a major component of a mission statement, as it directly affects revenues and cash flow.
Many factors define a company’s mission, and some have nothing to do with credit evaluation. The mission statement directly affects credit policy, though, as it helps companies determine factors like whether to:
- Extend credit to all applicants regardless their background and payment history with other vendors.
- Request credit-, financial-, and/or tax-related data.
- Extract a personal guarantee from the company’s owners or officers.
Those and other factors help ensure you only extend credit to customers that represent prudent credit risks. Credit granting is a company-specific decision, and the more you know about how your company’s mission statement impacts the credit evaluating and granting process, the better prepared you will be to establish and implement a credit policy that works best for your company.
The mission statement also impacts the company’s position regarding maintaining accounts receivable. The position will define how much leeway the company can allow past-due accounts.
What are the company’s goals?
Specify how much risk you are willing to assume. Risk tolerance places a limitation on the companies to which you are willing to extend credit. If any level of risk is acceptable, you’ll sell to anybody; on the other hand, if only an extremely small risk is acceptable, you’ll sell to only certain types of companies. This decision is a major factor in determining revenues generated by credit sales. Some of the measures of risk that can be set as goals are:
- Bad debt as a percentage of sales.
- Days sales outstanding (DSO), a measure of the average time receivables are held.
- Percentage of receivables allowed to age beyond a specific number of days (usually sixty or ninety).
- A business owner’s minimum FICO score, if that will be accepted in lieu of or in addition to a personal guarantee.
- Frequency of credit-limit review.
- Deductions as a percentage of sales.
The applicable statement in the credit policy puts numbers to the above measures: “Our goal is to limit bad debts to X percent of sales, DSO to X days, etc.
Who has specific credit responsibilities?
Most companies extending credit have a credit and collections department consisting of one or more people who manage the credit-granting process. When a company starts to extend credit, the structure of the department, including who reports to whom and what their area of responsibility is must be determined. The authority for setting credit limits also must be defined. For example, the credit manager may grant up to $10,000 in credit, but above that, the treasurer, chief financial officer, or owner must approve the contract.
Additionally, the criteria for delaying a sales order if a customer is slow to pay should be specified, as well as who has the authority to waive any credit hold on orders. Also, specify the accounts receivables condition that triggers collection efforts and the circumstances under which an account will be turned over to an external collection agency.
How will credit be evaluated?
As specifically as possible, a credit policy needs to address the minimum information credit seekers must provide. Typically, the list includes:
- The credit seeker’s legal name, entity type, and tax ID number.
- Names of company principals.
- A personal guarantee, if the credit seeker’s corporate charter shields owners from liability.
- Contact information including telephone and fax numbers, business and personal email and home addresses for the principals and the accounts payable manager.
- Trade references.
- Bank account information and contacts.
Determine how many of the above items must be satisfied before setting a credit limit for an account. Conservative credit grantors usually set a low limit for the initial purchase and don’t raise the limit until they are satisfied the account is meeting and will continue to meet payment requirements.
After receiving a credit application, verify the customer’s information by calling references and contacting the listed bank(s). Depending on the dollar amount requested, you also may want to obtain information from external credit reporting sources like Experian and Dunn & Bradstreet.
Credit accounts should be reviewed periodically to ensure the customer is meeting his obligations.
What are the terms of sale?
Terms of sale should be specified on every invoice, as should any penalties for not meeting payment criteria. An open line of communication with customers is a must, especially with customer unaccustomed to credit accounts.
Typically, payment-in-full is due between seven and thirty days after a customer receives the merchandise (expressed as “net [number of days]” on an invoice). Terms also may include a discount for early payment. Inducement terms often cut the bill by 2 percent for full payment within ten days; for example, “2 percent 10, net 30.”
Your credit agreement should specify any penalties delinquent accounts incur—legal fees and collection costs, for example. Also, specify your right to establish the jurisdiction if legal action is required to collect a debt.
“In a mature industry, when a new customer wants to buy products or services on credit, the seller goes through a specific process to determine whether they want to extend credit and if so, how much.”How will collections be handled?
No matter how good your policy for evaluating creditworthiness, some accounts will not pay on time and others will not pay at all. Once you begin to use credit to fuel growth, you must factor debt defaults against margins. Depending on your risk tolerance, this can be a lot of money, and you can’t afford to have a significant percentage of delinquent accounts. A documented collection strategy is essential and should include when you will consider an account severely delinquent and what you will do when the inevitable occurs.
Typically, the same person or department that extends credit also handles collection of delinquent balances. When that person or people have exhausted all internal collection options (letters, phone calls, etc.), it’s time to bring in a third-party collection partner. Statistics indicate once an account is ninety days past due, collections can be maximized with outside help.
There are two primary types of outsourced collection activity: early-collect programs (commonly called “soft collections”) and immediate action programs.
Early-collect programs typically are employed by companies without the manpower to manage day-to-day accounting as well as delinquency problems. “Soft collections” providers function as a customer-service department focused solely on encouraging customers to pay their bills.
Immediate-action collection programs become appropriate when a customer is more than 90 days past due, is no longer purchasing from you, and has ignored all of your collection efforts. That’s when to ask a “collection agency” to help. The older a debt is, the harder it is to collect, so the sooner you place it with an immediate-action collections partner, the better.
A good agency will make between ten and fifteen customer contact attempts within thirty to forty-five days after receiving the account. Your internal collector may not be able to devote that much time to each delinquent account. Additionally, the psychological and potential business reputation effects of escalation to an outside agency can create an urgency to pay.
The goal of the agency is to get your money in the shortest period. A good collection agency should recover 40 percent or more of what you are owed.
Once federal banking regulations change and companies serving the cannabis market gain the same financial resources available to the rest of corporate America, entrepreneurs will need to implement formal credit policies that allow them to manage and grow revenue in a trade credit environment. Establishing the controls necessary to operate when credit and accounts receivable are commonplace will set companies on the road to even greater profitability.
SAM FENSTERSTOCK is SVP of Business Development at AG Adjustments, a provider of commercial collection services. Previously, Sam was Director of Business Development at PredictiveMetrics, a statistical-based credit and collection scoring and modeling company that he helped grow and sell to SunGard (FIS) in 2011. Sam can be reached at [email protected]