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How to define your payment terms on your invoices (and why you should)
Small business owners spend a lot of time managing delicate relationships with customers. While it’s important to put on a friendly face, it’s also important to draw boundaries, especially when it comes to payment terms.
Though it may seem uncomfortable at first, clearly spelling out payment terms and enforcing penalties is necessary for the smooth operation of any small business. After all, entrepreneurs can’t afford to find themselves in a cash flow crunch as they await customer payments. In fact, a survey by Fundbox found that almost 80% of small business owners cut their own compensation when customers are slow to pay their bills, while 23% avoid hiring new employees and 20% cut their marketing and growth efforts.
To avoid sacrificing so much for the comfort of a customer or client, you should clearly define your terms for getting compensated when onboarding a new client. Furthermore, even if you’ve defined payment terms elsewhere, it’s important for this information to be displayed clearly on invoices themselves. Doing so can help emphasize your working process, and ensure the message doesn’t get lost before reaching the accounts payable department.
While there is no one-size-fits-all solution for developing payment terms, there are a number of best practices entrepreneurs can follow to ensure they’re getting paid on time without jeopardizing their client relationships.
What are payment terms?
Payment terms spell out a set of requirements for the compensation of a product or service, specifically when it comes to timing. After all, small business owners have their own bills to pay, and often can’t afford to wait until they’re compensated for their services.
To be fully transparent with a customer, small business owners need to clearly spell out exactly how much time the recipient has to submit payment for the invoice they’ve received. Typically, an entrepreneur determines for themselves whether their payment terms are due upon receipt of an invoice (right away), in a few days, weeks or months. The word “net” indicates that this timeframe starts as soon as the invoice has been sent. For example, if an invoice lists net-60, the recipient is expected to submit payment within 60 days.
Small business owners typically list their payment terms at the top of their invoice alongside the invoice date, invoice number and payment due date. Further terms and conditions, such as late penalties or early payment incentives, are typically listed at the bottom of the invoice.
Why timing is everything
In order to get paid on time, you first have to define what “on time” means. For some, that could mean instantly, for others that could mean 90 days, but for most “on-time” falls somewhere in between. Choosing a payment term will often depend on a range of factors (more on that later). First and foremost, industry standards and customer expectations can determine what a payment timeframe looks like.
After all, if your payment terms are considered tight by industry standards, it might rub customers the wrong way. At the same time, if your terms are too generous it could put the business in financial jeopardy.
Most industries will have a standard range, but nailing down more precise terms requires careful consideration of internal revenue cycles. Look at your payment cycles, upcoming bills and other expenses when determining how much leeway to give your clients.
For example, if the majority of your overhead is billed on a monthly payment cycle, consider payment terms of 30 or even 15 days to ensure you have the cash to cover your costs. If your biggest business expenses are billed on a 90-day cycle, perhaps you can afford to give your customers 60 days to submit payments. Giving your customers a comfortable period to pay your invoice is great, so long as you’re not putting your own business at risk.
Incentivize and penalize appropriately
Depending on industry norms and customer expectations, small business owners may also want to include penalties for late payments to encourage on-time compensation. While some customers may be taken aback by a late penalty charge, others will consider it a reasonable requirement, so be sure your terms fall within what is considered normal for the sector you operate in.
For example, while some industries may consider a fixed amount to be standard, like a $50 fee for every 10-days past due, others might have a standard percentage, such as 5% for every 15-days past due. Another way to help determine fees and penalties is to consider the true cost of late payments to the business. For example, if a late payment means you can’t pay your rent on time, and your landlord charges a $100 late penalty, it might make sense to establish a $100 late payment fee.
Instead of just using the stick, however, you may find more success with the proverbial carrot. Providing an incentive for early payments, like a $50 discount on the customer’s next order if payment arrives within 10 days, can prove a friendlier way to get paid on time. At the same time, however, it can take a chunk of cash out of your bottom line, or even set your other customers up to expect the same for their own invoices. It’s therefore important to carefully consider your own cash flow priorities and the true value of early payments before offering an incentive.
While it’s important to stand your ground, it’s also important not to be too aggressive in chasing payments. Polite reminders about upcoming payments and potential late fees can go a long way in ensuring there are no surprises if a late payment fee has to be charged. Furthermore, while some payees might make a habit of missing payment deadlines, others can be forgiven for letting a payment fall through the cracks on rare occasions. Take it case-by-case and consider the value of the relationship with that client as well as their payment history before enforcing a late payment fee.
Don’t be shy with your terms
Maintaining a good relationship with your customer while also conducting fair business can be difficult, but don’t let that get in the way of receiving payments for the products or services you’ve delivered. It’s up to you to set up boundaries when it comes to the quality of work a customer can expect, and also totally OK to set expectations for your customers on when they should pay you for your expertise.
When setting up payment terms for your business, consider things like industry standards and typical pay periods you’ve seen, but remember to also take into account how your business operates. At the end of the day, growing a business depends on having happy customers, and a healthy cash flow.
In this article, we talked about the importance of payment terms and how these can affect the profitability of your business. To dive deeper into setting rates, creating proper workflows and processes, and managing your customers, check out our Complete Guide to Getting Paid.