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Credit risk: a few easy steps can prevent major headaches, even extinction

Entrepreneurs are constantly setting up companies as new business opportunities arise. It’s called innovation, and that’s what Silicon Valley is all about. VCs put their money into these companies to help them grow with the expectation that they will make a great return on investment themselves—and they perform significant due diligence and risk assessment before investing.

So it always surprises me when many of these innovative companies that have been assessed for investment risk by their backers act cavalier when it comes to managing the financial risks within their fledgling businesses. Even more surprising is that many of the venture funds that have invested their money never question the company’s approach to financial risk management.

Many companies, particularly start-ups, sell on terms without checking out their customers for credit risk or taking steps to reduce risk. They are so intent on making the sale to show they have a real business (maybe even desperate) that the quality of the sale doesn’t matter. Many have been burnt when they don’t get paid, and others have gone out of business.

Make sure a customer’s credit is good

All of this is avoidable with a few basic steps—and the most basic of all is to check the credit worthiness of a new customer. It takes a minimal amount of time to do, yet in many cases it’s seen as an unnecessary hassle. (This is rarely a problem in public companies, as a basic SOX control on revenue recognition is a requirement to assess collectability. That is one area where SOX has added a lot of value.)

If it is not possible to establish a customer’s credit competence, get them to prepay, use a credit card or provide some sort of guaranteed financial instrument. I have rarely seen a sale cancelled because appropriate terms cannot be agreed upon, yet I have seen companies suffer a lot of pain when they realize, too late, that they have made a poor sale. It’s not only the loss of the receivable that hurts. The cost in time, effort and third-party services to chase the money can be exorbitant, too.

Make sure that credit stays good—and take basic precautions

In addition, companies need to reassess credit terms on a regular basis. Often I see companies check out credit risk and give terms for an initial sale, but they never reassess the customer’s credit risk thereafter, not even when the customer deviates from the agreed terms on that sale or a subsequent sale. Sooner or later that approach comes back to haunt them.

The same is true of credit concentration. Having most of your eggs in one basket is not a good idea, yet many companies do it. Whenever possible, take basic precautions to limit credit concentration, such as selling through multiple channels, or enforcing and continually reassessing credit limits on larger accounts.

Companies that sell overseas also take on significant risk with currency exposure when they sell on inappropriate terms or when the currency risk is not hedged properly. Given the constant headlines about the euro crisis and the considerable downside risk with little upside potential, why do so few companies spend no time considering and minimizing their risk? Beats me.

What I do know is that a small amount of time invested in managing credit and currency risk can save a lot of headaches down the road. It could mean the difference between being in business and becoming extinct.

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Do you know where your passwords are?

Keeping track of a zillion passwords and user IDs is a fact of working life, made even more complicated by all the devices we use. Because I work with different clients it’s even harder, because that almost always requires using a lot of secure applications. When I started with my current client, I received a three-page Excel spreadsheet of applications I needed logins for. I tried to make the user IDs and passwords easy to remember, but there were just too many—and each application required different user ID and password conventions. It wasn’t efficient (or particularly safe) to enter login information on the spreadsheet and keep it current and portable—I work on the client’s computer as well as a laptop, and the last thing I need was another password to secure the spreadsheet.

Most of us have probably used sticky notes—in our wallet, taped to a computer or pasted into a notebook—or virtual stickies littering our desktop or smart phone. And we all know that isn’t secure. This problem has even been in the news; one recent story is NPR’s “Prevent Your Password From Becoming Easy Pickings (Or PyPfbEp).”

I solved my problem with two simple solutions.

The first is a password manager or password wallet. These cloud-based apps store login information for all sites or applications and are accessible with one master password. Log in to the wallet app and it does the rest, bringing up the application login screen and autofilling the fields. It increases security, saves time and is easy to use. It’s also portable—because the app is cloud-based, one license covers all your devices, including cell phones.

These apps have been around for several years. There are many to choose from—check out this comparison from TopTenReviews. I use RoboForms: it’s simple and inexpensive at $9.95, and it works on all my devices.

The second solution is choosing a strong master password for my wallet app that I can remember. (Amazingly, the most commonly used password is “123456.” Avoid it.) Experts also say to avoid using actual words and birth dates, among other things. They suggest using the first letters and numbers of a phrase that you will remember. For instance, for “My #2 son’s middle name is Alex” the password would be M#2smniA.

I’m not that technically savvy, and I installed my password wallet in less than 10 minutes. It saves me a lot of time and frustration, plus saving a lot of sticky notes!

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Why are stock options so difficult to account for?

I attended the recent Stock Options Solutions annual conference for executives and stock plan staff from private companies targeting a liquidity event. One of my major quests was to identify why so many companies get caught up in stock option problems, which I have found to be an issue for our small, midsize and large clients.

There were 21 panels throughout the day and about 150 attendees. The sessions covered quite a range of topics, including ESPP essentials, international equity and tax accounting. I attended these panels:

  • Stock Plan Vendor Analysis, Selection and Implementation – Perfecting the Process
  • The IPO Abyss: Splunk-ing through the Challenges of Equity and Executive Compensation
  • Get Ready to Rumble: Making Your Equity Plan Data IPO-Ready
  • Avoiding Pre-IPO Financial Reporting Mistakes that Cause Post-IPO Restatements
  • Stock Options, RSUs and Other Awards: Key Considerations for Emerging Companies

In the pursuit of my quest, these three areas stuck out to me:

  1. Executive compensation is an art and a science. There is a fine line between controlling windfalls and motivating management and employees. It is vitally important to have critical data and support (as well as documentation) for how executives are compensated with stock. The compensation committee is a complex group that balances investor control with equitable compensation. It appears that directors’ fees are up due to added regulatory risk and complexity, and the overall allocation of stock as compensation has made things more complex, leading to the potential for more mistakes.
  2. Pre-IPO mistakes in equity can be made on even the simplest calculations. In many examples at the conference, simple spreadsheets calculated options incorrectly, leading to errors in proper accounting treatment. In addition, timing of the valuation (409A) can have a significant impact depending on how often options are being awarded.
  3. The type of rewards your company will utilize requires careful thought. Should you use restricted stock units? Incentive stock options? Something else? It is critical to design a proper system that allocates the intended percent of the pool that executives, employees and investors receive. Many fear the power institutional shareholders have based on their ability to scrutinize compensation once a company files its S1.

Confusion about properly accounting for stock options is usually based on the following issues:

  • The accounting rules are changing too fast.
  • Employees administering the options leave the position or the company.
  • There are inadequate records of the grants.
  • The source information is in many different locations.

The good news is that all of this can be managed with proper systems and processes, and the proper human interaction. The key is to juggle the growth of your company with the needs of a first-class stock option recording system, and to maintain the discipline to review it on a regular basis—ideally quarterly.

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‘Investing in the business’ doesn’t have to mean embracing chaos

Have you ever been at a well-controlled company and heard at a company meeting that the board wants to accelerate the company’s development by “investing in the business”? These days, statements like this send shivers down my back. Why, you ask? Well, in lots of instances it can mean chaos has just been authorized. And sometimes it can signal the beginning of an untimely death spiral for the company. It’s ironic, because in today’s business environment where risk assessment is fundamental, investment in the business is, in many cases, not even considered a risk.

I have seen companies (both public and VC-backed) make the “we are investing in the business” announcement. Within weeks they are recruiting, or changing management, or adding infrastructure like crazy, so they can grow revenues, accelerate product development, scale up, or be in a position to scale when revenues grow. Unfortunately, in nearly all instances they allow basic controls to disappear and they no longer manage their business to the tight set of metrics that they used to get to that point. I find this incredible, but it happens so much. The effect is that after a few months, existing staff feel the company is out of control and leave, and investors get nervous. Company results more often than not tank as the desired revenue growth does not happen as fast as desired—but the expenditures do happen, and cash balances drain at a dramatic rate as the investment takes place.

Eventually, but normally way too late, the board slams on the brakes, and an exercise in picking up the pieces and bringing the company back to normal begins. In some instances, companies need to raise more funds as they have burnt through their cash balances, and they struggle or fail to do so because their metrics are now awful. That means they sell shares at a much lower valuation, get bought out at a much lower valuation, or maybe even go out of business. In nearly all cases, the company and the employees are much worse off than they were in the first place.

This whole cycle is completely avoidable by implementing a few basic controls:

  • The decision to invest in the business must have goals attached, and a cost benefit and risk assessment analysis should be performed before the proposed investment is approved.
  • The planned investment should be well defined and divided into small sequential segments with milestones. Investment in the next segment should take place only after the previous milestone is met, with positive results.
  • If an investment is not working, the board should not be afraid to come to terms with it and change course as soon as possible—not wait until a big problem arises.
  • Investment in the business should be secondary to managing the business to key metrics and fundamentals.

Smart, properly controlled investments in the business can be extremely beneficial, but poor or uncontrolled decisions can be disastrous—and everyone pays a price.

How will your company react when those decisions are made? Hopefully they will do it the smart way, or you will probably experience the chaos.

 

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No crystal ball? No worries—AICPA report crowdsources the future

What lies just around the corner? What skills do you need to be successful tomorrow?

My crystal ball isn’t any less fuzzy than yours, so I turned to the AICPA report, CPA Horizons 2025, which provides excellent advice about current and forecasted trends that will impact the profession. While the report is focused on the CPA profession (it’s based on the comments of more than 5,600 CPAs), much of the subject matter can be applied to keeping your finance department strategic and relevant to your business.

Here are two of the top themes for me.

1. New technology opens doors—and adds to risk.

Changes in technology offer incredible advantages and efficiencies, but they also introduce risks in new areas. The prevalence of mobile technology and the ability to access applications from just about anywhere have increased our expectations for the availability of information and we expect financial reports much faster. (Gone are the days of having to drive to the office to make a journal entry or run a report, thank goodness!) Not only does this quicken the pace at which the accounting team must do its work, but it also opens the door to potential errors and fraud. Electronic documents can be altered in an instant. The security and privacy of information is at risk.

The finance organization has to stay on top of changes in technology to drive efficiencies in the business. Stay alert, assess the technology, ensure your internal controls evolve to mitigate new potential risks and keep a sharper eye on potential fraud—it may be harder to detect.

2. Lifelong learning is a clear advantage.

According to the report, education will remain a cornerstone of preparation for certification and of ongoing activity throughout a CPA’s career. Strong technical accounting knowledge will continue to be a foundational requirement, but it won’t be sufficient on its own.

The AICPA report suggests that we need to devote more time to staying current with regulations and standards, both domestically and globally. At the same time, accountants must have a broad knowledge of business and soft skills and not simply focus on technical accounting.

I think this presents some challenges. How are you planning to keep up with technical accounting and rules and regulations that are evolving at a fast pace? At RoseRyan and other professional accounting organizations I have worked for, we set a goal for a certain number of training hours for the year. If your organization doesn’t provide this type of motivation, try setting a personal goal for continuing education.

What about soft skills? I see accountants placing inordinate value on technical accounting knowledge and ignoring soft skills such as communication. Yet, in my experience, the finance pros with the best-developed soft skills are the ones with the most success. They have an easier time obtaining information and working with others; and they are better able to influence people and have more highly developed leadership skills. All of that is critical in moving your organization forward.

Want to know more about strategic thinking and key finance initiatives to keep you ahead of the curve? Check out our latest Intelligence report, Strategic Finance in Action.

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