ON PAYMENT TERMS
In a B2B relationship, too often, payment terms are poorly used, in a way which makes no financial or business sense and which is detrimental to the provider.
Let’s go back to when it all started: 1929, when the world faced his biggest demand crisis. Companies were not able to sell their goods. To attract clients, they started to play on prices, which generally went down of about 30%, but it was not enough. So they tried a more drastic approach: giving away their goods today, and hoping for payment later. Consumer credit came to help B2C, and inter-companies credit, also known as payment terms, came to help B2B.
Let’s first understand the logic behind properly thought inter-companies credit.
Healthy payment terms
How payments terms should be designed? On a case-by-case basis, taking into account the cascade of payments happening downstream, triggered by the payment of the end client.
So what matters is who is the end client, and when they pay. Let’s take two examples.
Example #1 – B to B to C
Consider the case of a wholesale company W, buying yogurts from a dairy company D, and selling them to customer C. The end client is C. So payment terms between W & D should be set to match the time W needs to receive payment from C – what we will call its operational/cash cycle. In this example, W buys yogurts from D, ships them within 3 days to its store, and sell them within 7 days to C. So about 10 days after buying the yogurts from D, the wholesale company receives the money from client C. Assuming an operational buffer of a couple more days in order to process D’s invoice, payment should reach the initial provider somewhen between 20 to 30 days after the deal is signed.
Example #2 – B to B
Now, consider a SaaS company S, selling software to our wholesale company W. This time, the end client is W. So payment terms between S & W should be just about the operational time to process the provider’s invoice, let’s say 15 days, maybe 30 maximum if W bundles its payments once a month.
This is the most straightforward version of payment terms. Pay when you are paid, and if you are the end client, pay now.
Unhealthy payment terms
Let’s recall first that in traditional economics, time creates risk, and risk shall be compensated. So time is money.
Things get messy when non-financial companies start to play the banking game.
In our example 1, if the yogurt company D accepts payments terms of 180 days from the wholesale company W, then D basically grants them a loan. D charges an interest to W as the wholesale company is able to freely dispose of the money during 6 months (this interest charge would be included explicitly or implicitly in the yogurts price). Here, the yogurt company plays banker.
That’s the positive and somewhat fair version of the game. The more realistic is that the wholesale company thinks it has more leverage than the yogurt provider, and thus imposes long and abusive payment terms, not aligned with W’s operating/cash cycle, and with no compensation for the time D waits for its money. Goal of W here is to have more cash at any given time, because it could be invested somewhere else and make even more money.
Good business practices
Payment terms are not inherently bad. They are here so the chain of companies you are in finances itself. On top of that, it’s also an amazing marketing trick to sell your products. But they shall be used with care and a spark of business logic.
• Align payment terms to your client operational/cash cycle, meaning when its own client will pay.
• If you are not a bank, don’t play the bank. Do not offer or accept payment terms that are not aligned with your operation/cash cycle.
• Include in your pricing a compensation for the loan you grant to your client by accepting payment terms. Don’t forget, it’s also named “inter-companies credit” for a reason. The shorter the terms, the lower the interest charge.
• If you are on the client side and are not organized well enough to pay your providers in a timely manner, cut into bureaucracy. Go solve this.
• If you are on the client side, and tempted to play the greedy cash-holding game, simply don’t. If you already received payment from your client or are the end client, simply pay your provider. It helps to maintain a good business relationship. After all, you wouldn’t like it if your employer takes 180 days to pay your salary without any business reason, right? So don’t do the same.