For the purposes of this blog, I have adapted a version from WikiLeaks and will define the law of unintended consequences as: “… when the actions of people have effects that are not as anticipated or intended.”
It is in the seeking or giving of debt that this situation is most pronounced. When we borrow, we are taking money from another party which expects it to be paid back, plus interest. When we extend credit conversely, we expect it to be paid back with interest.
The problem with each of these scenarios lies in the expectation of paying back what is due or being paid for what was lent. If something happens to either the financier or the borrower, all former rules and expectations are cancelled.
When seeking finance to fund your business, it is wise to try and ensure you have the capacity to pay off the debt within the terms of the contract and the time is right to borrow. Businesspeople however do not always show the greatest prudence when rushing to earn their first million, or create a business overnight, or to be hailed as a successful businessperson. Consequently, they may borrow inappropriately.
When debt is cheap, businesspeople and their businesses are encouraged to borrow. The problem for start-up businesses is that they have no history of revenue and profits. Start-ups therefore have no real idea of whether they have a sustainable business. They are just working to an unproven business model.
The problem for existing businesses is that they may be under the advice of somebody who believes that debt is the way forward for the business, which in turn may:
be financially undercapitalised;
not have an adequate group of investors which can bail them out of trouble if it arises;
efficient business operations;
be short-staffed or lack professional and committed employees;
have inadequate credit management control; and
be operating in troubled times.
Of these issues, the lack of credit management control and risk management disciplines also create additional problems. If you do not complete due diligence on your customers or have good sales disciplines, the offering of B2B credit to the wrong customers will add another layer of difficulties.
Anybody who has worked through a previous business downturn will tell you, there is nothing worse than seeing:
your customers going out of business and trying to find replacement customers;
your Debtor Ledger dollars dissolved in front of your eyes as some of your remaining customers enter in to insolvency administrations with a debt owed; and
insolvency administrators start seeking refund of preferential payments.
Traditionally we used to see many businesses label themselves as being into sales and marketing, where the emphasis was always on raising the next invoice. Whether that invoice would lead to a timely payment or be profitable, was rarely considered.
In the good times, some of these businesses did survive for a while because there were always new sales to hide the bad debts. In a downturn, there is nowhere to hide from bad debts because all too frequently, there are no new sales, or if they are, not of the dollar magnitude to protect the solvency of the business.
Irrespective of the business circumstances at the time decisions are made, there are always unintended consequences which can affect your business badly. When you make the wrong decisions immediately prior to, or during a downturn or a recession, the law of unintended consequences kick in with greater emphasis.