Some businesses try to encourage early payments from customers by offering what are known as trade terms. Typical trade terms might be 1/10/30. Those terms mean that the buyer gets a 1% discount if paying within 10 days, and the balance is due in 30 days from the date of the invoice.
Sounds simple enough, right?
But I wanted to know if trade terms work in the real world, especially from the point of view of the company extending the trade terms. So I asked John Mariotti, President and CEO of the Enterprise Group and formerly the CEO of Huffy Bicycles. He’s had a lot of commerce experience, both as buyer and vendor. Here’s what he had to say:
Question: Why do vendors offer early payment discounts?
Mariotti: There are five reasons the vendor would be willing to offer a discount to encourage early payment:
- Companies want their money. It sounds simplistic — but isn’t. Getting paid early is important in business.
- They want their money ahead of other people. The buyer may not have enough money to go around.
- The longer it takes, the greater the risk that something happens and you don’t ever get your money. The earlier you get paid, the less risk.
- It helps you from the perspective of working capital. The more money you have in hand, the less need to find working capital from other sources.
- It lowers your costs of borrowing and can even substitute for loans. The more money you get in hand, the less you have to borrow. This is important in times when it’s hard to borrow money or interest rates are high.
Question: Is there ever a downside to offering discounts for early payment?
Mariotti: Yes. Consider:
(1) Discounts cost you money. Again, it sounds obvious — but discounts add up. A 1% discount for monthly invoices amounts to 12% interest a year. A 2% discount, as some companies offer, would amount to 24% interest.
(2) Look out for the “double whammy.” If you are having trouble getting a buyer to agree to a price increase, you might attempt to negotiate by offsetting the increase with an early payment discount. But the customer may squeeze you over price AND expect the discount — and still pay you later.
Question: Are there any other advantages to offering early payment discounts?
Mariotti: Sometimes those who plan to sell their companies will offer early payment discounts to help reduce their DSO (days sales outstanding) number. This could make the company appear more attractive to acquirors.
Question: Now for the big question: do early payment discounts actually work?
Mariotti: In my experience, many customers take the discount and still pay later.
If that happens, you may not be able to do much about it. You can call them and try to jog the payment. Penalties usually don’t work. You can try to charge the customer back to recover the discount, but then it becomes a confrontational negotiation and usually the penalty gets negotiated away in the end.
I’ve had the best response by going back to the buyer and saying “That wasn’t the deal we made. We’d like you to honor the deal you made.” Sometimes that has an impact.
If you must go back to enforce the terms, the way to do it is to call and talk to a human being. The second best approach is an email to someone you’ve previously spoken with, requesting them to intercede on your behalf.
Question: What would you advise a small business? Should they ask for early payment trade terms?
Mariotti: First I’d assess the situation. What is the prevailing practice in your industry? Are competitors offering discounts? Do customers expect a discount or not?
If you discover that a discount is expected, then a modest discount of 1% makes sense in most industries.
Some customers normally pay late — so by offering an early payment discount you also are raising the issue of the time value of money up front. And that’s a valid issue.
If the prevailing terms in your industry are to pay in 30 to 45 days, be sure to build that into your plans. Sometimes you build it into a price negotiation. You say, “Instead of charging an 8% increase, I’ll knock that down to a 6% increase and also offer you a 1% discount if you pay early.”
And always document the terms, even if just in an email exchange. If there’s a change in personnel at the other company, that documentation will be needed.
Question: Is a discount of 10 days realistic?
Mariotti: 10-day discounts are usually not going to happen, unless the buyer has electronic funds transfer capabilities. The practical aspects of cutting checks and mailing them makes a payment in 10 days unrealistic. Consider 15 days instead.
Question: What about the situation where a small business is selling to a large corporation? Would you offer a discount?
Mariotti: No. If I were selling to WalMart, my pitch would be, “WalMart, you can borrow money cheaper than my company — why don’t we just agree on 15-day terms and I’ll reflect that in my pricing? Otherwise, I have to borrow at a higher rate than you – and also reflect that in my pricing.”
Most large corporations are good for payment. Don’t waste your cash discounts on the highly solvent companies, but rather on the companies you’re nervous about.
Question: You’ve given a lot of advice. What points would you like to close with?
Mariotti: I’d like to emphasize 3 points above all:
- It is always good to get your money sooner.
- In case of noncompliance, fall back on the ethics: “That’s the deal we made.”
- Beware of the double whammy, which is where the customer takes the discount and you still don’t get paid any sooner.
Thank you, John Mariotti.
Editor’s note: this article was originally published at the OPEN Forum.