The Importance of Working Capital in DTC Startups

I often pose a hypothetical question to DTC entrepreneurs to understand how they think:

Would you sacrifice 5% of your gross margin in order to get 30 days better payment terms with your manufacturer?

For the past cycle, the answer was oftentimes “no” because (a) companies want to maximize gross margin to appeal to outside investors, which implicitly means (b) they have or think they will have adequate access to financing to fund their working capital cycle.

However, as times are rapidly changing (writing this after 2 months of COVID quarantine) and outside financing is becoming more expensive, it’s a good time to think about how to optimize working capital cycles to reduce the need for outside financing altogether, which will pay off even when markets recover.

To illustrate what I mean when I say working capital cycle, I’ve laid out a hypothetical DTC company selling $100 widgets at 60% GM that gets their product from Asia. For simplicity I’ve assumed the manufacturer is the only vendor to pay (in reality you would have logistics costs and overhead as well).

Let’s assume the supply chain looks like this:

• Day 0: Place order with manufacturer with 60 day lead time in minimum order quantities of 1k units, pay 30% down: 1k units * $100/unit * 40% COGS * 30% down = -$12k
• Day 60: Completed goods received by freight forwarder, 70% due on receipt = -$28k
• Day 90: Goods have crossed the Pacific Ocean via ocean freight and are on trucks to the fulfillment center
• Day 95: Goods arrive at fulfillment center, joining the rest of the average ~3 month stock (~4 turns per year)
• Day 177: Goods make their way through the inventory queue (FIFO) and are ordered by the end customer
• Day 180: Investment is recouped when Stripe pays out 3 day later, customer receives their order with 3 day shipping: 1k units * $100/unit = +$100k

A flow chart of the above would look like this:

If this were your company it would mean you would have to finance $12k for 60 days and then $40k for 120 days for each batch. Due to the “J-curve” of each batch, your cash on hand will limit the number of production runs you can do simultaneously. For instance, let’s say you started your business with $50k of funding. With the working capital cycle above, that means you can afford 1 run of -$40k cash with a $10k cushion, netting $60k cash and recognizing $100k of revenue at the end of 180 days. But what if you want to grow faster?

You will need either more outside financing, or better terms across your supply chain.

Going back to the original question, let’s see what happens if you call up your manufacturer and they accept your offer of effectively five points of GM in exchange for net 30 financing on the 70% remainder otherwise due upon delivery. Better yet, see if you can get them to move to no deposit, which they should be happy to do when you’ve established that you’re a good client who pays their bills on time.

Here’s the flow chart from above except with 0 down, net 30 on delivery, and 55% GM:

Now you would have to finance $45k for 90 days before earning $55k profit, instead of $12k for 60 days followed by $40k for 120 days before earning $60k profit. While you pay a little more and net a little less on this batch (and receive it in the same amount of time), you’re only out cash for half the time as before, meaning you can place orders faster than before with the same cash balance, and therefore grow revenue faster.

With $50k of cash, in the scenario immediately above, you could place your second order at day 90 knowing you wouldn’t have to pay the $45k until you made $55k profit from the first order on day 180. In the first scenario you wouldn’t be able to place another order until the first one was paid off.

Here’s a comparison of how far $50k can get you with each scenario (assuming no overhead). New orders are highlighted yellow, cash low points are highlighted orange, and revenue is highlighted green:

Drawing out the scenarios to 18 months, you can see that with better working capital terms you can achieve $600k of cumulative revenue in the second scenario vs. $400k in the first scenario.

By now you might start to see the limits of this GM trade. By dropping below 50% GM you won’t net enough profit to roll into the next order without additional financing, so this doesn’t work for everyone.

However, there are lots of other things you can do to optimize your working capital cycle: negotiating for a smaller minimum order quantity (typically at the cost of margin), choosing faster more expensive air freight vs. cheaper slower ocean freight, and carrying more or less inventory (risking overstocking or stocking out). All have their trade-offs and are of differing value depending on how your business is set up.

At Reformation we run this analysis for every DTC company we evaluate, and have created a proprietary working capital score, which we’ll go into in a future post.

Let us know your thoughts!