If you have debtors and it is time to collect, then this is a question that has plagued many creditors. However, there is no right or wrong solution; it all depends on the nature of your business and the amount of debt to be collected.
Firstly, do you have a dedicated in-house collection department? Or is this task handled by you or one/more of your employees as part of their routine tasks? The first step in the process is obviously sending your debtors a letter asking for the payment (check out our article on How to Collect Small Business Debt). Do most of our clients respond favorably to this? If your answer is yes, as in 80% or more of them do, you might not need to outsource your debt collection, particularly if you are a small business.
There are several advantages to collecting debt ‘in-house’:
- More revenue: Part of the payment in outsourced debt-collection goes to the collection agency or law firm. By keeping it in-house you can avoid this significant outlay.
- Better relationships with your customers: Remember, your debtors are your customers. The cost of retaining a customer is only one-fifth the costs of acquiring a new one. Keeping that in mind, it wouldn’t be a good idea to sour existing relationships with your customers by bringing in third parties who are only interested in collecting the debt and nothing else.
- No staffing problems: The most cited complaint is that small businesses do not have dedicated staff to follow up on, and collect customers’ debts. However, the debt collection process can be automated by using software.
- Stay in control of the debt collection process: When you outsource it to a debt collection agency or law firm, you do not know how exactly they are going to deal with your debtors. There is the Fair Debt Collection Practices Act to be followed, and if the collection executives at the debt collection agency do not comply with the provisions of the Act, it is you who is going to end in legal trouble, not to mention the chances of collecting the debt diminishing significantly.
But generally speaking, if three-fourths of your debtors do not pay on time, you definitely have a serious problem on your hands. Not only can chasing this be time-consuming, it has the added effect of disrupting your cash flows. In such a scenario, it would make financial sense to outsource this to professional debt collection agency, which can not only collect the debt, but also do so faster. They have the experience and the manpower to achieve this.
If your staff handles it as part of their tasks, then outsourcing debt collection can also free them to do other tasks that might be more beneficial to your business.
There is this anecdote doing the rounds on the internet that if Microsoft founder Bill Gates, the richest man on the planet, stopped to pick up a $100 bill that he had dropped, the minute or so spent on doing so would cost him more than $100 – he theoretically makes more than that per minute, and so it would be better to focus on running his business enterprise.
The same question can be asked of your small business – Can you or your employees make more money for your small business doing something else with the time you or they spend on the debt collection process?
Why you should outsource debt collection
Debt collection agencies and collection law firms usually work on a commission basis. That means if they don’t collect, they don’t get paid. So they have a greater incentive to collect the debt than any of your staff. There are some who work on a flat fee, but then again, they claim that if they don’t collect, no fee is levied.
It is also hard to collect debt when it is an old one. Theoretically, the older a debt gets, the harder it becomes to collect.
|Age of debt (in months)||Likelihood of recovering the debt|
Source: Commercial Law League of America
If you have ever tried to collect old debt yourself, you should be able to relate.
As you can see, a debt that is six months old has only a 58% chance of getting collected. As the age of the debt increases to nine months, it becomes less than half, and reduces to around a quarter when it becomes a year old. A debt that is two years old has a 14% chance of getting collected, on average.
You also have to factor in inflation – how much would a $3000 debt that someone owed you in 2013 be worth today? How much have you spent on attempting to collect it already? How much have you lost in interest payments because you borrowed this amount from someone else to pay your own creditors? Would it make more sense to spend more time and resources on it, or would it be better to entrust it to a debt collection agency, who will only charge you if they are able to collect the debt?
Now what does this mean for your business?
Let us say one of your debtors owes you $5000, and the debt is now some four months old. Going by the statistics, you have only a 74% chance of collecting the debt. That means on average, you could hope to collect 74% of $5000, or just $3700. Compared to the $5000, $1300 is huge loss to absorb, but sometimes it is better to get $3700 than to be left with less than this amount at the end.
Now if you entrusted it to a debt collection agency or collection law firm, let us say it charges 20% for a debt of this age. If it collected $5000 from your debtor, it would keep $1000 and hand over the remaining $4000 to you. This is not only a gain of $300 over the previous scenario, but also more likely, as debt collection agencies and collection law firms do nothing but collect debt. Even if it charged 25%, it would still be beneficial to you monetarily. At 26%, it becomes equal to the chances of you recovering your debt on your own, but the likelihood of them recovering it is greater as they are more motivated than you. This example illustrates how a debt collection agency can be good for your business.
This is also why you should always look at the contingency rates of the debt collection agency before you entrust it to one. You need to compare it against the table mentioned earlier and ensure that it is lower, not higher.
Are contingency rates the only thing you should look at?
The contingency rates apply to individual debts. But before planning to outsource your debt collection entirely to a third party, you also need to look at their success rates.
Let us say, there are two collection law firms, A and B.
A charges only 20% as collection fees and has a success rate of 50%.
B charges 25% as its contingency rate, but has a success rate of 75%.
Assuming the total debt owed to you by all your creditors is $10,000, and you entrusted it to A; what would happen is that it would collect only $5000 (as its success rate is 50%), then charge you 20% of the debt collected (this amounts to $1000) and leave you with $4000.
If you entrust it to B, it would collect $7500, based on its success rate of 75%, charge you 25% of this amount, which amounts to $1875 and hand over the remaining $5625.
It is better to have $5625 than $4000 in your cash till on any given day.
Debt collection agencies and collection lawyers also employ what is known as skip-tracing – if a debtor has moved or ‘skipped town’, they try to track the debtor to his/her present address. For instance, they might look at credit card billing information to see if the person is regularly ordering items to another address using his/her credit card – the legal or ‘good’ debt collection agencies have tie-ups with credit card companies that allow them to view this kind of data. Otherwise, they might look if the debtor lived with someone else before and try to look up that person’s current address to find out if the debtor is living with him/her. These are just two techniques, and there are several more methods that they employ to find out where a debtor lives or at which address/phone number he/she can be contacted.
- The rule of thumb is to always try to collect the debt first yourself. This should not leave you or your ‘in-house’ collection department for three months from the date of invoicing. After 90 days, you may entrust it to a debt collection agency or debt collection lawyer.
Now, you may have looked up different debt collection agencies and law firms, compared their contingency rates, and found that it makes sense to entrust debts that are no older than six months to one agency; debts that are six months to nine months old to another agency; debts dated nine months to a year to yet another agency; and a fourth agency to handle debts that are more than a year old. This is a highly possible scenario.
Should you have multiple debt collection agencies and law firms?
This is also dependent on whether you can manage multiple law firms and debt collection agencies all at once, that is to say whether or not you have the time to deal with all of them at the same time. A debt that is less than six months old might not be collected by the first agency, and it might then pass to another agency after it becomes older than six months. The problem with this is, your debtor might sue you for harassment, especially if he/she had told the first agency that he/she did not want to be contacted again regarding the debt, and the first agency failed to pass on this information to you, so that you could convey it to the second agency.
A lawsuit is never pleasant for a small business; even if you win, attorney fees alone can take a huge bite out of your total monies. It also makes the debt even harder to collect, if there is a court order that the debtor has secured in his/her favor against being contacted for debt collection. So a single debt collection agency is what is recommended. It might be one that is good both in terms of contingency rates and success rates for recent debts, but not so much for older debt; or the other way round. How you choose one depends on which would be more beneficial as a whole.
If you have a lot of old debts, then a good debt collection agency or lawyer that has a high success rate with this might be a better choice than a debt collection agency which has a high success rate when it comes to collecting recent debts. This applies even if the ‘old debt specialist’ collection agency charges higher by way of contingency fees for recent debts. What you recover at the end in total might be worth more than if you had contracted the services of a ‘recent debt specialist’ collection agency.
If you shop around, you might find that some debt collection agencies and law firms make it attractive for you to outsource your debt collection to them – they offer a contingency rate model for debts that are less than a year old (and even this might vary according to the age of the debt, like three months or less, 3-6 months, 6-9 months, and 9-12 months), and a flat fee model for debts that are older than 12 months. If you do your homework, also factoring their success rates as well – see the example mentioned earlier – you could end up with the best debt collection agency for your small business.
Overall, outsourcing your debt collection to a professional debt collection agency or law firms works out to be cheaper than doing it ‘in-house’. Because debt collection lawyers and agencies often have multiple clients, they are able to take advantages of economies of scale and offer you low rates, while still making profits.