The charmed life of the software business – or why making things is hard

July 28th, 2015

Software businesses have a charmed life. In almost no other field can you turn your own knowledge, skill and perseverance into a successful, profitable product quite so quickly and easily. That’s not to say that building a successful software business is child’s play – but you are at a significant advantage compared with almost all other forms of business. As someone working in embedded systems, I come into contact with a lot of people with very naive ideas about the challenges of making and shipping a physical product, and I thought I might summarise some of them and look at how best to overcome some of these obstacles.

Starting a business – easier than pie

Here in the UK, it’s incredibly easy to start a business. If you’re prepared to trade under your own name, you can be a “sole trader” simply by telling HMRC that you’re now self-employed, and committing to declaring your business dealings on a tax return once a year. With only slightly more effort you can set up a partnership with one or more other people, and for £15 and some very trivial bureaucracy (which in most cases is basically just completing an online form), you can start your own limited company.

Our example software business, QuickProfit Ltd, is started by Joanna in her bedroom, using a computer and an internet connection she already owns. Depending on the nature of her product, she may need to buy some software tools, or pay fees for the use of a hosting service or cloud platform, but basically she can get started developing her product right away with very little expenditure. Good luck to her!

Getting paid

Let’s say that Joanna sells her software product directly on the web, and uses Paypal to take payment. When a customer pays, the money is transferred immediately to her Paypal account, and if she then wants to withdraw that money (to pay her own salary) she only has to wait a couple of days for the money to clear through to her bank account. She can pretty much live hand-to-mouth, spending the money as it comes in. However, if she sells a mobile app on the Apple App Store, she’s in for a nasty surprise: Apple only pay out a) when you’ve earned $150 b) 45 days after you’ve reached that $150 threshold. Subsequently they pay out at the end of every month, a month in arrears. Effectively, she (as a small one-woman software firm) is lending Apple her money (“giving them credit”, to use the jargon) for at least 30 days. Apple benefit from holding her cash and consolidating it into one payment a month (which saves on admin and bank charges). She has to accept this as part of selling on their platform, even though it’s effectively a small company lending money to one of the richest companies in the world! That’s part of what you sign up to when you join the world of commerce.

The default position for business-to-business transactions is that the vendor gives credit (usually 30 days as a minimum) to the purchaser. Why do we do this and not just pay up front?

  • business-to-business transactions have no “customer protection” in law. The 30 day credit period gives the buyer the opportunity to quibble over the bill if the product is not what they expected, or if it is defective.
  • before computerisation, inter-company payments, cheque clearing and bank transfers were tedious clerical tasks that involved huge amounts of manual clerical work, so giving 30 days credit gave plenty of time for the purchaser to make the necessary arrangements to pay their bill
  • if you paid up front, and your supplier turned out to be a charlatan, they could just take your money and run away, leaving you to try and sue them to get your money back.

So 30 days is customary, but by no means the only option. Larger companies generally seek to get better credit terms from smaller ones – big corporations have been known to demand 60, 90 or even 120 days terms when they think their suppliers are sufficiently desperate for the work. If you’re a supplier and a customer asks you for a quote you can, of course,  ask for more favourable terms: 7 days terms are not unreasonable. A friend who works for a major accounting firm says that they make their invoices “payable immediately”, which is nice if you can get away with it!

Payment up front (often known as “pro-forma”) is sometimes asked for when a small, unknown company first deals with a large supplier, or if you’re making a single one-off purchase.  To get credit, you will need to apply for a “credit account” with your supplier, and this generally requires some sort of credit check. They will want to see some proof of the legitimacy of your company – the traditional way being a letter on company headed notepaper (yes, really!). These days just supplying your company registration number (if you’re a Limited company) is often enough for the vendor to be able to check you’re creditworthy via an electronic credit file search.

The credit stretch problem

Now, Joanna’s grumbling somewhat about Apple’s payment terms to her friend Karen, who runs a manufacturing business, MakeStuff Ltd. Karen points out that this situation is much worse for her because of credit stretch (this is a term I’ve coined, because I can’t find an actual term for this problem in any literature). She buys raw materials, spends time making them into her product, and then sells the product on. In her case, she gets 30 days credit from her supplier, the product takes a week to make, and then she sells it on and gives 30 days’ credit to her customers. Can you see the problem here?

  • week 1: Karen gets an order for a product. She has none in stock, so she tells the customer there is a two-week lead time. She places an order for her materials, and they arrive at the end of the week. Her supplier invoices her immediately, on 30 days terms.
  • week 2: Karen manufactures her product, and ships it to her customer at the end of the week. She invoices her customer on 30 days terms.
  • weeks 3 and 4: for the sake of this example, Karen is on holiday and nothing happens.
  • week 5: Karen receives a final demand from her supplier, and pays the bill.
  • week 6: Karen gets paid by her customer.

The problem is the credit stretch between paying her supplier and getting paid herself: she must have enough working capital (in the form of accumulated cash in her business’s account, or in the form of a bank overdraft) to pay her suppliers’ bill and tide her over until she gets paid.

Credit stretch is the most common way for small manufacturing businesses to go bust – if a customer delays payment for some reason, the company can find that it runs out of working capital. If you can’t pay your suppliers’ bills, they will refuse to supply you any further goods (in the first instance – later you may get a visit from the bailiffs!) and so your whole business can grind to a halt, unable to work because there’s no money to buy materials and pay wages. One small firm I once worked for used to pay its bills very late and then rotate round between several suppliers in order to continue to obtain raw materials. This is a dangerous sign that the company is short of cash, and indeed they did effectively go bust a year or two later when a major customer refused to pay a bill.

Credit stretch is a real problem for manufacturers, because it means that your business has to be profitable enough to cover the losses associated with extending credit to your customers (especially if you have to use a bank overdraft to cover your stretch). However, if you are a retailer, this situation is turned on its head: you buy goods wholesale and get 30 days terms, and you sell them to customers for cash, now. You can then bank the cash and earn a bit of interest on it until it’s time to pay your wholesaler. A British chain of supermarkets, Kwik Save, was based entirely on this: they sold goods to retail customers at, or in some cases slightly below, the wholesale price. By only accepting payment in cash, and banking the cash several times a day (they got their bank to calculate their interest hourly instead of daily!) they could effectively exploit the 30 days’ credit they got for free from their suppliers, and make a profit despite selling goods at a loss! It helped that the interest rates were fairly high in the 1980s when they were in their heyday.

One very wise startup founder I heard speak at a conference said “always start your business by being a retailer” – he started by being a UK distributor for a product that was made in the USA. You take relatively little risk, build up your business and start building up a cash pile you can use to then move into making your own product. You also get valuable market insight by talking to potential and actual customers. And you don’t have to worry about credit stretch.

Credit stretch is just one reason why manufacturing is hard, and I hope to cover some more of them in later posts.


One Response to “The charmed life of the software business – or why making things is hard”

  1. Random Writings » Blog Archive » Why making things is hard, part 2: stock and suppliers Says:

    […] « The charmed life of the software business – or why making things is hard […]

Leave a Reply