We have witnessed a range of payment challenges among our customers and our trade network over the last year. Three main categories have emerged. Below we will talk about the challenges that we commonly see among small and mid-sized buyers and sellers as well as proven best practices to address these crippling issues.
1. Prepayments to Suppliers
We often see buyer prepayments change hands and nearly as often we hear of buyer prepayments vanishing. This has been true across commodity sectors, although it is particularly common in agricultural transactions.
The story is often the same. A seller says “if I could only get some cash, I could secure more high quality supply upstream, scale up, secure more warehouse space, etc.” Buyers eager to scale up reliable relationships offer cash advances, presumably buying exclusivity in a competitive market space and ensuring that cash constraints will not derail supply growth. The problem is that in many cases, the cash is mismanaged and simply disappears.
It is rare to hear of a case where a buyer provides a prepayment to an unproven supplier. But even for proven suppliers, conditions can vary widely between transactions and campaigns. Once a cash prepayment has been issued, the buyer has little ability to direct its use and can only hope for the best.
2. Direct Contractual Payment Agreements
Contracting a physical commodity deal is simple, in concept. The seller supplies goods meeting the buyer’s specifications, the buyer then pays for the goods. In practice however this is hardly straightforward and has toppled many exporters, not just novices. It’s an enduring problem.
For small and medium-sized transactions, direct payment is undesirable and needs to be carefully managed to avoid becoming a nightmare. We know of too many stories of sellers hopping on international flights, at their expense, to demand payment long after goods have changed hands. One significant payment issue can truly disable an export firm. Settling disputes across borders, whether in the courts or through arbitration, is typically costly and time consuming.
We strongly discourage direct payments. They create unnecessary risk for both sides, assuming both sides are in fact acting in good faith. It is far better to use a trusted payment mechanism that ensures prompt payment once contractual obligations are fulfilled.
3. Letters of Credit
When documentary letters of credit (DLCs) are well structured, there is no higher form of mutual payment and performance security. But two common challenges remain with DLCs.
First, DLCs are not the cheapest form of payment guarantee and the higher the number of advising banks that are involved, the costlier they are. In other words, when payment security is most needed, the cost and complexity of DLCs generally rises.
Second, there are numerous ways to transact incorrectly with DLCs. This past year alone, we saw a range of cases where credit was inadvertently mismanaged by credible buyers leading to payment delays. At a glance, both the buyers and the sellers in these instances were sincere but payment problems nevertheless ensued. The most common root causes were buyers providing improperly structured letters of credit to suppliers who encountered delays. This tied up capital that these buyer owed to other suppliers to which letters of credit were not issued. In short, these buyers overextended themselves financially as a result of poor credit management. In these cases, both parties lost out — the buyers missed out on good quality supply and the sellers were stuck with fixed costs, for warehouse space as an example, in addition to being left scrambling to line up other buyers.
Best Practices: What can buyers and sellers do to gain payment certainty?
First, buyers and sellers need to agree on obligations and demarcations of duties. As we discuss in another article, simply altering contract terms to shift obligations does not necessarily add to improved execution certainty. Choosing the correct INCOTERMS to leverage competencies usually serves as a solid guide.
Next, payment should be transferred using a trusted mechanism once contractual obligations are proven to have been met. We do not believe that companies can survive by shipping goods and hoping that wire transfers from buyers eventually come in — at least not indefinitely. Instead, a low cost trusted payment method is better. This protects both parties and a buyer’s funds are tied up for as short a time period as possible. If a seller fails to fulfill commitments, the buyer’s funds can be quickly redeployed. This is essential for businesses that require constant throughput of feed-stock or otherwise procure goods just-in-time.
We sometimes hear push-back from sellers. “What if the buyer does not agree to using secure payment methods?” In our view, if a buyer is not willing to make a payment commitment to a seller when it is fair to do so, do not work with them. Good deals rely on buyers and sellers balancing risk and trust for mutual benefit.
Comflo offers low cost payment processing solutions that help buyers and sellers reduce risk and save on transaction costs. Comflo’s blockchain software provides verified buyers/sellers, secure transaction management, and best-in-class risk management practices for the commodity trading industry.