In good times many lenders are willing to approve a loan which is secured only by accounts receivable. The ability to value A/R seems more straightforward than it actually is when considering underwriting. There are several legal and practical problems with collecting A/R which will reduce its ultimate value to a lender if the lender ends up needing to monetize the A/R following default. This post will discuss A/R and collecting the A/R.
Let’s begin with the basics: what is an account receivable (“A/R”)? It’s a common misconception that A/R is the payment. A/R is actually the right to receive the payment. When a payment is made, the A/R ceases to exist.
So, when a lender takes a blanket lien against A/R, the lender is really encumbering the right to receive payment from third parties in the future, not the cash in the bank account.
Misunderstanding this can cause problems in a few ways. One of the most common issues I have seen is when the borrower reports A/R that is actually just revenue.
In a hypothetical scenario: the borrower sells equipment. A buyer orders some equipment online and at the same time pays for it. Then borrower ships buyer the equipment. Borrower generates an invoice to account for the payment and the transaction closes.
Oftentimes an unsophisticated borrower will assume that this transaction created an account receivable, when, in fact, it did not. Further, the borrower will then turn around and report the transaction as an account receivable on a borrowing base report or loan application. Doing so can cause issues with covenants and underwriting for the lender if the lender is not aware of the misstep. Simply stated, there is no A/R in this hypothetical and therefore there is no collateral to collect on if things go south.
Another problem I commonly see is when a lender overvalues the A/R when considering underwriting or loan modifications. A/R’s true value for a lender is the lender’s ability to monetize the outstanding A/R at the time of the default. Three basic things work against the lender in the scenario when the lender needs to collect A/R.
First – the reason the lender is seeking to collect A/R is because the borrower is in default. Usually a borrower is in default because business has been going poorly. Poor economic performance usually also means that the A/R that exists has diminished over time because the borrower has been doing less business.
Second – the practicality of collecting A/R is difficult. The lender is immediately at a disadvantage because the lender doesn’t have the books and records of the borrower to show who actually owes money on an outstanding A/R. It’s great to look at a balance sheet and see $10MM in A/R, but it’s another thing all together to track down the specifics. I have been in situations where the A/R records were all on a cloud server which was deleted. Next, the lender will oftentimes need to pursue the A/R in its own name, one way or another. It’s likely that the account debtor (the person who bought the equipment) would simply ignore a demand by the lender to pay up. There a number of reasons for this. Part of the problem is that if the lender needs to actually resort to bringing a lawsuit, all of the evidence of the A/R is really the borrower who may not be helpful on the witness stand.
Third – Finally, there is the unknown relationship between the borrower and the account debtor. Most all of the account debtors have some excuse about why they did not pay the invoice. Usually these excuses include: the equipment was no good, I have a credit that’s not reflected, I have a deal with the borrower where I don’t have to pay, I returned the item, or – in cases of fraud – I have never heard of the borrower. (All of which I have heard). The facts related to all of these excuses will likely be unknown to the Bank when it tries to monetize the A/R and, if the excuses are true, may result in an offset to the A/R.
There are clearly a number of hurdles to monetizing A/R. From a preliminary perspective, the A/R that exists when a lender takes a lien against A/R will not be the A/R that might be available for collection at a later date. The lender is simply betting that the borrower will continue to generate A/R at a rate acceptable even in a time of default at some unknown time in the future.