Authored by ACG member and MTSI Chief Financial Officer Valerie Underhill. Originally published on Aronson Fed Point:

In today’s competitive environment, executives must work especially hard to grow revenue and control expenses. But it is equally important that they not overlook a ticking time bomb that can clobber, or even destroy, their business: a receivable that cannot be collected has far reaching ramifications.

It is common knowledge that the government has adopted an aggressive stance on awarding contracts to small and disadvantaged businesses. Often these awardees elect to subcontract a significant portion of the work to other companies. This means that these subcontractors are taking the credit risk of the small prime contractor. If the small prime contractor experiences financial stress, their subcontractors may quickly find themselves sharing in the financial woes of their teaming partner, sometimes to the point of having to write-off the receivable altogether. Such a loss can have significant ramifications. For example, most bank lines have covenants related to earnings. A receivable write-off can trigger a covenant breach that can increase borrowing costs or cause the line to be pulled.

So, what is a responsible subcontractor to do? 

The first step is to get an honest assessment of the prime contractor’s financial health. If anxiety exists regarding their financial capabilities, require that the prime contractor put in place a safeguard that protects your company.

One solution is to establish an escrow account that directs payments to a specific account and requires an escrow agent to disburse funds in accordance with an agreement among the parties. This has its own disadvantages, though. In the event of bankruptcy, an escrow account may be deemed to be part of the bankrupt company’s estate and, therefore, offers no protection to the subcontractor (in a recent real-world example, the subcontractor had to take a multi-million dollar loss).

A stronger approach is having the prime contractor sell the receivable to a third party who then pays both companies their pro-rata share of the proceeds. This approach protects against bankruptcy risk as the owner of the receivable is a third party. While this tactic is gaining acceptance, care must be exercised to make sure that the transaction accomplishes a “true-sale” of the receivables. A bonafide legal opinion should be obtained to confirm the true-sale nature of the receivable.

Example: Assume a prime contractor owes your company $100,000 and that you have a 10% margin. If you have to write-off $100,000, it will take another $1,000,000 in incremental revenue to recoup that loss. The cost of the receivable sale program should be around 1%/month (much lower for larger receivables). So, for $1,000, a company can protect against a loss of $100,000. Even if your company helps pay for the transaction fees, the benefit can be enormous as you have ultimate protection.

Takeaways:

  1. Make loss avoidance a high priority among your executive team.
  2. Conduct an honest assessment of all your prime contractors.
  3. If there is any concern about the financial situation of these contractors, require that they implement a receivable sale program.