I recently made a short presentation at Experts 4 Entrepreneurs about making sure customers pay what they owe. I had a lot of fun with it and thought it might be worthwhile to share here. I’ve embedded the PowerPoint slides below, but slides to my presentations often don’t tell the whole story, so here’s a little detail.
The presentation starts with an illustration about my not-so-pleasant experiences donating blood. (Apparently, my body needs all its blood.) How is that relevant to making sure you get paid? Because cash is a business’s life-blood. When customers don’t pay their invoices, they starve a business of a critical resource that it needs to stay healthy.
Bad debt is costly
Consider for a moment what bad debt does to your profits. Let’s assume your business has a profit margin of 25%. So if you make $1 million, you’ll have $750,000 of expenses, leaving $250,000 of profit for the year. But if ten percent of your customers don’t pay, that leaves you with $150,000 of profit. That’s a reduction of 40%. So ten percent of bad debt reduces your bottom line by four times that amount.
If your profit margin is lower—say ten percent—the effect of bad debt is even more severe. In that case, a bad debt level of ten percent would completely wipe out your profit. Now, a ten percent bad debt level is pretty high, but the examples do show the effect of bad debt on the bottom line. A small percentage of non-paying customers has an out-sized effect on your bottom line.
My objective in the presentation wasn’t so much to provide specific tools and techniques on how to pry money out of the hands of deadbeat customers, but rather to help business owners to think about their relationships with their customers from beginning to end to help them optimize the chances that they’ll get paid.
In the presentation I talked about three periods of the lifecycle of customer relationships: first, the early negotiations when you agree on what you’re selling and how much your customer will pay, then the contract itself when a deal is made, and, finally, the break up. As an analogy, I used the dating, marriage, and divorce stages of a romantic relationship that goes sour.
Due diligence (dating)
When a couple is dating, they spend time together to make sure they’re a good fit for each other. If they’re not a good fit, they’ll eventually go their separate ways. The early negotiation phase of customer relationships is a bit like dating. You make sure the products and services you provide are what your customer needs and that your pricing is suitable for both you and your customer.
I believe that it’s more important to make sure you’re doing business with decent people than it is to make sure you have good contracts. Of course I think you should pay attention to your business’s contracts, but it’s just as important to make sure you vet your customers and suppliers to make sure they’re honest. I understand that you can’t necessarily limit your business interactions to honest people, but you should seriously consider the toll imposed when you have to fight every step of the way for what honest do as a matter of course. I would encourage you to alter your agreements with such people accordingly.
Over the years I’ve had a number of clients who’ve had problems with their customers and the relationship has gone sour. Often they call me up because their customers are refusing to live up to their end of the bargain. So I’ll take a look at their contracts and talk it over with them. Very often my clients decide that it’s not worth suing, because of the time and expense of a lawsuit and the stress and distraction that goes along with it. So even if they have a good contract, when their customer turns out to be a bad apple, they often have no real recourse.
That’s why it’s important to make sure your prospects are a good fit for your business if you’re going to extend trade credit to them. I’m talking about due diligence. Due diligence doesn’t have to be extensive, and it doesn’t have to cost a lot. But it’s always a good idea to check out your customers to make sure there aren’t any red flags. You can hire a lawyer or a firm that specializes in investigations, but there’s a lot you can do yourself without spending a ton of time.
The first tool of choice, of course, is Google. It’s amazing what you can find when you Google a company’s and its owners’ name, telephone numbers, and email addresses. You can also use review sites like Yelp, www.ripoffreport.com, and www.complaintsboard.com, as well as the Better Business Bureau. Government resources, such as the Secretary of State’s website and court databases are also helpful. And of course, you can hire an attorney or an investigator.
Contracts are a wonderful tool for making sure your business relationships go smoothly. As I wrote in Contracting Triage, contracts have numerous purposes, including helping the parties think through the details of their relationship, serving as a guidepost for the parties throughout their dealings with each other, and, of course, preserving legal rights that can be enforced in court. Although most business is done without signed contracts, you can enjoy many of the benefits of contracts, even when you don’t have a formal signed contract.
Of course, signed contracts are ideal, and you can improve the chances you’ll get paid by including certain provisions. First, contracts should include a clear description of what products and services you’ll be providing, as well as pricing. Also, payment terms should be as favorable to you as possible so that you’re extending as little trade credit as your customers will agree to. Payment in full up front is best, but often a pipe dream. But in many industries companies can negotiate up-front payment of at least 50%.
Other contract provisions give you leverage to withhold benefits from your customers when they don’t pay. If you’re creating a website, for example, you can condition transfer of the copyright to the customer on payment in full. And if you’re selling goods, you can reserve a security interest in the goods to secure payment.
Charging interest for late payments and securing the right to receive attorney fees if you have to go to court also improve your position and increase the chances that you’ll get paid.
Pulling levers (divorce)
Particularly, if you have a good contract, you’ll have some levers to pull if your customers decide to renege on their promises to pay you. First, you might have the right to withhold the benefits you promised. You can refuse to assign the copyright to work product you created, or you can foreclose on your security interest in goods you sold.
If the situation is bad enough and there’s enough money at stake, you can hire an attorney to send a demand letter (aka nastigram) demanding payment and threatening consequences for refusal. And, of course, you can take them to court or hire a collections agency. If your contract has interest and attorney fee provisions, you’ll be much better situated if you decide to take legal action. If the dispute is relatively small ($5,000 or less in Missouri), you can go to small claims court, which is an informal proceeding where you don’t necessarily need a lawyer. The Missouri Bar has published the Missouri Small Claims Court Handbook, a resource that describes in detail what small claims court is and how it works.
One of Steven Covey’s Seven Habits is to begin with the end in mind. That’s good advice … to think about your customer relationships from beginning to end, to make sure you’re doing business with honest people, that you have good contract provisions, and that you have levers to pull if your customers don’t pay. Cash is the life-blood of your business. I encourage you to think about your relationship with your customers from beginning to end to help you optimize the chances that you’ll get paid.