The agribusiness economy is driven by contracts, from leases for farm ground, supply contracts for inputs and forward contracts to sell grain, to futures contracts to protect your position. With each of these transactions comes a level of counter-party risk; the risk that the other party will not live up to their end of the agreement. This, to some extent, is an inherent risk of doing business. However, just as you mitigate other business exposures through insurance, there are steps agribusinesses should take to lessen counter-party risk, too. The economic forecast remains unclear, without a doubt, but there are significant pressures on agribusinesses, such as rising interest rates, high commodities and input prices, and tight labor markets, which make this an opportune time to evaluate your counter-party risks.
A sound business practice is to periodically perform an honest risk assessment and evaluate your company’s vulnerabilities. For many, this is an informal process, and boils down to what keeps owners and managers up at night. We recommend reducing the list to writing, if you haven’t already, and to evaluate those risks with your internal team and key advisors.
As part of this process, you should consider the vulnerabilities that arise through business partners. For example, do you rely heavily on a single vendor for key inputs or services? Do you have significant credit exposure with a large customer? If something happened to this business partner, how would that impact your operations?
We often think of this risk in terms of bankruptcy or fraud, but what about involuntary factors, such as weather? An agribusiness should have insurance to cover their facilities if severely damaged by a storm. If this business is your primary supplier for a crucial product, how will their loss impact your operations?
In most cases, companies have limited knowledge about the financial stability of their trading partners, vendors and customers. It’s important to stay vigilant for cues that could indicate potential issues (slow or missed deliveries, changes in the timing of payments, etc.). It wasn’t long ago when the world was surprised by the sudden bankruptcy of MF Global, a global brokerage firm. The majority of MF Global’s customers were caught off guard by this news – but what steps could those customers have taken to minimize losses and disruptions to their operations?
Once you understand where you have exposure, the next step should be to mitigate those risks to an acceptable level. At a minimum, there are certain business practices you should always follow.
One such practice is tightening contract compliance. It’s not uncommon in the agriculture industry for agreements to be made over the phone or settled through a handshake. This habit can sometimes translate into poor internal controls when formal contracts are needed. For example, an agreement is reached over the phone, contracts are drawn up and sent to the customer, but there is no follow up for unreturned contracts. A few basic controls around this process can go a long way to eliminating this situation and the headaches, or worse, that could follow if a dispute arises.
Don’t forget about contract modifications either, which are often overlooked. Even if such modifications are minor and a new contract isn’t warranted, a safe practice is to follow up any verbal agreements with an email to help avoid any miscommunication.
Another simple practice to follow is to know your business partners, their capabilities and their limitations. This knowledge can help protect your business if a customer or vendor happens to overextend themselves. To illustrate this, let’s say a grain merchandiser has a request from a customer for delivery of 100,000 bu. of corn. The customer has historically farmed 500 acres, and this volume would put them on the upper end of their traditional production levels. How likely is it that the customer will be able to meet this obligation? Does the farmer have adequate crop insurance for this position based on the actual production history (APH)?
Has anything changed in the customer’s operations that would make this production level more or less achievable? For example, maybe they began leasing a new 80-acre farm. Does the customer have the financial resources to honor their commitments in other ways if production comes up short? Is it possible to corroborate any of this information before entering into the contract?
As with other vulnerabilities, another way to mitigate risk is diversification. While you may have a great relationship with a particular vendor, it’s not always in your best interest to rely solely on one source for critical products or services. It’s also not usually advantageous to change vendors; however, there is minimal cost to establishing relationships with alternative suppliers and service providers. When the unexpected happens, having those lines of communication open can alleviate some of the challenges of adapting your business, whether temporary or permanently.
Put it in Practice
Ultimately, it’s up to business owners to decide on their risk tolerance. Unfortunately, when issues do arise, most companies are blindsided and left scrambling to minimize the effects. Some simple business practices and vigilance can go a long way to reduce the impact.