Why Entrepreneurs Need to Get Paid On Time
When you think of a small business owner, you probably picture a person who has struck out on their own, standing apart from, or even against, the country's biggest corporations.
The truth? A lot of small companies work for and with huge businesses, doing contract work in exchange for payment. Remember the early 2000s movie "Real Women Have Curves?" The family business featured in that movie illustrates this perfectly—a small business paid by Bloomingdale's to make dresses that will be sold in the department store chain.
Most businesses are small
In the U.S., 99.7 percent of companies, nearly 29 million of them, qualify as small businesses, according to the U.S. Small Business Administration. With so many small companies, it makes sense they'd be working with large firms, pointed out Ramana Nanda, the Sarofim-Rock Professor of Business Administration at Harvard Business School.
In fact, household-name companies like Apple, Coca-Cola and Whole Foods work with suppliers that have far fewer employees than these businesses combined.
Power imbalances tend to surface when it comes time to be paid for the work. Small businesses spend lots of money making the stuff the big companies need, and rely on the payments to stay afloat. Entrepreneurs need to get paid on time.
The smaller the business, the harder the wait
If compensation comes late, business owners can't do much about it.
Contracts typically require payment to these small businesses within 30 or 60 days, Nanda said. Over time, "the number of days (it takes for them to pay) has been creeping up," he said. Big companies will miss payment deadlines and leave smaller businesses in the lurch.
In an effort to work around this, contracts will be drawn up to give large companies a discount for paying early. But sometimes, the companies will "take the discount and not pay on the contracted date," Nanda said.
It's a problem that Obama-era regulations sought to temper—large companies signed onto a government program that ensured small businesses got paid quickly for their contract work. Once enacted, one small business owner told the Washington Post that he was paid in two weeks by the companies participating in the program, compared to 75 to 90 days from other large companies he contracted with.
A cashflow problem, solved?
These long waits can leave entrepreneurs unsure if they'll make payroll, Nanda said. In order to pay their people and make more stuff to sell to big companies, small businesses will sometimes take out loans from banks.
"The challenge really is, we're in a world where some of these small business suppliers are not using the money in the bank to invest in their companies," he said. They're essentially lending the borrowed money to big corporations by providing them with materials they drag their feet on paying for.
Nanda's research suggests that even an incremental decrease in the time it takes a small business to be paid for its work can impact the growth of the business. That's why entrepreneurs need to get paid on time by their larger partners, he said.
For a fee, intermediaries pay small businesses for the services rendered to big companies; and then collect payment from the big companies on behalf of the small businesses. That way, the small business doesn't have to wait to be paid and doesn't need to spend the time worrying about its relationship with the big business, Nanda said.
Most people "don't think about how the timing of when a firm gets paid can have an impact on its bottom line," but it does, he said. "There's a relatively simple solution—get large companies to pay on time. In the event that that does not happen, there are these financial intermediaries."
Entrepreneurs need a go-between
In the past, an intermediary like this would have been called a "factor," he said. Factors didn't have a very good reputation in the business world—they were seen as payday lenders and something a small business would only rely on if it were on its last legs.
Big companies got turned off by factors helping small companies to get paid for their work, Nanda said. Factors would "aggressively try to pursue loans from buyers, which would cause them to pull back their business."
But times, attitudes and approaches are changing. Financial intermediaries take a more subtle tack to helping small businesses get paid for their work. More and more companies turn to this service to fix a cashflow problem.
"Part of the benefit is that as technology has gotten better, the ability to run credit scores on these businesses (has gotten better)," Nanda said. "That allows these intermediaries to provide more services to these companies than was possible before. It's a better time to be a small business today than it has been some years ago."
Few appreciate this new era, he said. The United States' small firms are still waiting on trillions of dollars from big companies. Small businesses, especially those that "want to be growing very quickly," could benefit from a go-between, Nanda said, and should educate themselves on the pros and cons.
"I think it's helpful for (all small business owners) to understand the benefits it will have and how it stacks up against the cost," he said.