Over the last few weeks, we have begun to see signs of panic that have not existed for many years. Banks are starting to fail, investors are starting to panic, and defaults have increased. The federal reserve has hiked rates to the highest levels since the financial crisis in an effort to halt inflation by reducing the amount of money sloshing around the economy.

While none of the current economic data indicates an imminent recession, we need look no further than the financial conditions of 2006 and 2007 to see how quickly the tide of the economy can shift. Warren Buffett once famously observed that “[o]nly when the tide goes out do you discover who’s been swimming naked.” Indisputably, the tide has been receding, as evidenced by the recent banking failures, and we are seeing more and more businesses in financial distress. So what can a business owner do to hedge against the risk of an economic downturn?

Be Proactive

In all cases, delay greatly limits options available to head off or address economic distress. For most small and mid-sized businesses, economic stress comes from one of three areas: (1) production, (2) sales, or (3) legacy costs/debt service. Identifying potential risks in advance helps to reduce the costs of disruption and decrease risk over the long run.

A disruption in production can be caused by supplier or employee costs. While businesses have a degree of control over their ability to hire and fire, for many businesses, if a key supplier were to cease production, the entire supply chain would grind to a halt. Often times there are few substitutes for needed parts and materials, and finding a new source can take months.

A disruption in sales is generally caused by a decrease in industry demand or a reduction in demand by a long-time customer. A customer that ceases operations or files for bankruptcy results in an uncollectible receivable. While this can be painful by itself, the situation becomes further exacerbated when a trustee takes over the customer and attempts to recover payments made before the customer closed its doors. While the payments could have been otherwise appropriate, the mere timing of the payments could allow them to be clawed back.

When these disruptions occur, the temptation exists to just “ride it out” and secure financing to continue operations until conditions improve. This results in an increase in debt, which results in lower profit margins, and if conditions further deteriorate, the affected business quickly becomes insolvent.

Identify Risks

Neither customers nor suppliers will ever admit liquidity shortfalls or other looming problems. Problems with secured lenders will generally be concealed until or unless disclosure is absolutely necessary or the affected business has already failed. Therefore, businesses need to pay attention to red flags or changes in behavior among their business partners, such as requests for changes in payment terms, late payments by customers, and late shipments and production delays by suppliers. Deviations and excuses are red flags to be explored further. Readily available public records such as UCC filings and lawsuits can help ascertain whether business partners are having trouble paying bills as they become due or are turning to questionable alternative lenders when they cannot obtain financing from traditional sources.

Confirmation of distress usually involves a catastrophic event. Such events typically involve one of the following: the landlord evicts the business from a commercial property, the business abruptly shuts down, or the business is placed into a receivership or bankruptcy proceeding. By then, the options for risk mitigation are dramatically decreased and immediate action needs to be taken to avoid further losses.

Reduce or Mitigate Risk

Once identified and assessed, the appropriate strategy will depend on the potential exposure, existing business model, and relationship with the distressed supplier or customer. For customers, a business needs to be mindful of both (1) the risk of non-payment and (2) the risk that a receiver or bankruptcy trustee will claw back payments well after they were made. Strategies for minimizing risk can include:

• Shortening payment terms. While prepayments are preferred, as a practical matter, payments to be received at the time of delivery or within a very short period afterwards limit the amount of exposure from uncollectible receivables and usually provide options in case of insolvency proceedings.
• Obtaining security. If a business must extend credit to a customer, having liens against the customer’s property will increase the chances of payment in case of insolvency proceedings.
• Requiring a letter of credit or commercial guaranty agreement. These items provide for payment by a third-party in case of a default by the customer. However, depending on the third-party and the contract, a risk of non-payment may still exist, especially in the case of bankruptcy proceedings.

For distressed suppliers, the options are more limited and include:

• In the short term, it may be prudent to become more actively involved with the distressed supplier. Distressed suppliers generally will not rebuff customer requests to assist in operations. This does not require direct input into all operations. Rather the focus is on assisting in ways that will minimize exposure. For example, concerned businesses can purchase and retain ownership over raw materials to be processed by the supplier. For short-term liquidity issues or situations in which an alternate supplier cannot be easily identified, a business can make prepayments necessary to bridge liquidity gaps and to ensure continuity of production.
• If a supplier is exhibiting substantial risk and/or chronic long-term liquidity problems, exploring alternative supply sources will be necessary. This is obviously a less than ideal approach given that alternative sourcing will usually take months, and there may be few alternatives available within the marketplace.

Avoid the Dreaded Contagion

Difficult times require bold measures. In my experience, many businesses fail because the marketplace shifts, and the businesses incur substantial debt while waiting for financial conditions to get better or for revenues to improve. The issue is not the failure of a single supplier or customer but rather a market-wide shift in supply or demand.

If a disruption is imminent or possible, an attorney can assist in developing strategies for avoiding or responding to the disruption. From a cost-effectiveness standpoint, in addition to potentially avoiding costly debt-service and litigation, employment of an attorney to take preventative measures can be the difference between the realization of a small loss and absorbing a catastrophic loss. For businesses that have already undertaken a substantial debt service in hopes that their revenues will improve, an attorney can help with negotiation and structuring of these obligations, keeping a small problem from becoming a much larger one.

For many businesses, the difference is a matter of survival. At a certain point, operations are too costly to continue even if revenues do increase, and at that point, the only option is to liquidate and sell the business and its assets to a competitor or new entrant to the market. In an economic downturn, those that identify and address their risks proactively are those that are positioned to thrive and grow when the economy rebounds.