Read this Before Extending Credit to Customers

Everyone loves reeling in a fresh customer. And what better bait is there than easy credit? But be careful: Before taking on a new job you need to balance liberal credit terms with a prudent assessment of your customer's ability and desire to pay.

"When you work hard to win a new account, there's a real temptation to extend credit to close the sale," says Mary Adams, principal of Trek Consulting, Winchester, Mass. "But at some point you need to put on a different hat and ask, 'Can we afford to give this product or service if we don't get paid?'"

It's tempting to postpone the credit check until after the sales effort is done. But the fact is, successful credit procedures should begin before a lot of time is spent cultivating an account or new client. "It's a good idea to do a credit check early on," suggests Marilyn J. Holt, principal of Holt Capital, a Seattlebased investment advisory firm. "Selling is hard enough without wasting your time talking to someone you are going to turn down."

Background Check

Most business owners look to a commercially obtained credit report as the first line of defense against a deadbeat account. The typical credit report, after all, offers a wealth of information on matters such as:

1) Current and prior addresses. How long has your prospect been living at the present location?Length of time is evidence of stability.

2) Litigation history. Have any civil lawsuits been filed against the individual for non-payment of debts? These represent potential liabilities that may affect your prospect's ability to pay.

3) Payment history. Does the person have a history of falling behind in payments? If so, your own payments may be delayed.

4) Mortgage problems. Is your prospect's lender about to foreclose? If so, there may be nothing left to pay your bill.

5) Other creditors. Have other organizations recently requested credit reports on the individual? Too many such inquiries might indicate the person is becoming financially overextended.

Keep it Legal

Before ordering a credit report, cover your legal bases. "You must meet two requirements before you obtain a credit report on a consumer," cautions attorney Robert A. Pasch, a partner with the Madison, Wis.-based law firm of Murphy Desmond. "The first requirement is to obtain the consumer's permission. Make sure you get it in writing."

As for when and where to get permission, the most logical place is a credit application form that conforms to law. "Selling to consumers subjects you to laws protecting individual rights," says Pasch, whose practice emphasizes the rights of creditors and debtors. "You should avoid asking questions about marital status, age or any other personal characteristics, as doing so could violate the federal Equal Credit Opportunity Act as well as state laws."

Your second requirement, Pasch says, is to have what the law calls a "permissible purpose" for the credit report. Entering a credit transaction with a customer qualifies as permissible. Conversely, if the customer is to pay in full up front, then you no longer have sufficient purpose and must not seek a credit report, even if the customer has given you permission.

"Technically, a written authorization from a consumer removes the permissible purpose requirement, such that you only need one rather than both," Pasch says. "However, there can be a gray area, so the conservative approach is to have both."

Once you have your legal bases covered, you can obtain credit reports from three nationwide agencies that provide information on consumers (see the sidebar "Credit Reporting Agencies" on page 38). You also may find local credit agencies with relevant information.

Credit reports are important, but don't give them more weight than they deserve. "While the reporting services play vital roles in the credit-granting process, bear in mind that they are offering historical information that is not updated every day," Adams cautions.

As for other sources of information, bear in mind that many states maintain online databases of civil litigation. These allow you to find out if your prospect is the target of lawsuits, or currently has paid or unpaid legal judgments.

Unfortunately, in the real world a lot of useful information just isn't available. A bank will likely refuse to confirm a person's current balance, for example, even if your prospect signs an agreement authorizing such disclosure. Current business creditors who are in a position to report if your prospective customer is in the habit of paying on time may shy away from angering a customer who owes money. Your prospect may only allow you to verify employment status and give you clearance to confirm actual salary level.

Before You Offer a Contract

Suppose you determine, as best you can, that your prospect is credit-worthy. Is it time to offer a contract. Not quite. Pasch suggests you first determine the answers to the following two questions:  

1) Does the individual who will be signing the contract actually own the property? If the answer's no, you may run into problems down the road. Suppose, for example, that a customer does not pay your bill, either from recalcitrance or because of financial overextension. In such an event you can ordinarily take steps to obtain payment by placing a lien on the customer's real estate. "If after obtaining a lien you still are not paid by the customer, you can start a lien foreclosure lawsuit through the court system," explains Pasch. (For more information on liens, see "Stake Your Claim" on page 28.) "The end result of this can be a forced sale of the real estate in order to pay your obligation." The important point here is that you cannot take this route if the person signing the contract does not actually own the property.

Assuring true ownership, unfortunately, is very often a matter of faith. A prospect may balk at digging around to find the requisite documentation, and the fact is that in many cases your comfort level will be satisfied with a simple question and answer. For large projects, though, you may want your attorney to check out the property deed.

2) How much equity does the individual have in the property? If a property lien is a great tool for collecting what's due, it won't be worth much if your customer does not have sufficient equity in the property to cover your bill. If a bank holds a mortgage for the full value of a $100,000 property, for example, there will be nothing left for you in the event of a customer bankruptcy.

As you might surmise, making the right credit call is more of an art than science. Rather than relying on a clearcut formula, you have to blend together information from a number of sources. "Unfortunately, nothing is guaranteed," says John McQuaig, managing partner of McQuaig & Welk, Wenatchee, Wash. "You just need to gather as much data as you can and make your decision on that basis."

As with so many other business activities, a successful credit decision demands knowledge of human nature. "You need to listen to your instincts," Adams says. "Look your prospect in the eye, and talk about the person's experience with other vendors. Does the individual pay within terms. Read the prospect's body language."

Once you have determined that your customer is credit-worthy, offer a legally binding contract. Contact an attorney experienced in the area of consumer credit to be certain that your own document complies with all federal and state laws.

Watch Your Accounts

Once you extend credit, keep a close eye on your customer's file. "Either have a professional examine your accounts once or twice a week, or do it yourself," Holt advises. "If you let things go for a month, some accounts will run away from you." Take steps to keep your customers current, Holt suggests. "Set a limit on how much you will carry. If customers can't keep within that limit, then you have to stop everything until they pay up."

The message for the business owner looking to boost revenue through extending credit is clear: Offering favorable terms is a great way to land new customers, but it has to be done the right way. "Getting overextended is a huge risk," McQuaig cautions. "One of the biggest reasons for business failure is the improper granting of credit to customers."