LONDON, United Kingdom — In the fashion industry, being sold in a prestigious store can make or break a young brand. Most retailers buy a product wholesale from a brand and then sell it to a consumer. Retailers capture the largest amount of value in the entire supply chain: the raw material suppliers capture the smallest amount, the factory captures a bit more, the brand captures more still, and the retailer captures the most. However, retailers continue to reinforce a longstanding problem: they push the risk of their business down the supply chain.
Retailers do this, primarily, by extracting “payment terms” from brands, which means the brand will be paid, not when it delivers the clothes the retailer ordered, but at a later date. This creates a big problem, because the designer needs money to manufacture more goods and run her business. If she’s not paid on time, that’s much harder to do. Issues around payment terms are getting worse: across sectors, the average amount of time it took a US corporation to pay an invoice increased from 35 days in 2009 to 46 days in July 2014. Every day a business isn’t paid for its work, the underlying financial health of the business weakens. This practice creates a man-made capital hole in the supply chain, with vast implications for emerging fashion brands.
Payment terms often lead to one of two outcomes. If a brand is cash-strapped, it either has to grow slowly or secure investment to prop up its early operations. The other, widely used option, is for a brand to turn to a factoring company. A factorer uses an order from a store — say, Barneys buys 100 dresses — and loans the brand money at high interest rates to produce those 100 dresses. Then, 60-plus days after the product arrives in the store, Barneys pays the factoring company, which, in turn, pays the brand. An article in the Wall Street Journal summed up how these practices “create deficits at suppliers that have to find financing, raise prices or squeeze other firms along the supply chain.” The capital hole made by this practice trickles down the supply chain, touching every part of the process. Supply chain financing, which includes factoring, is a business estimated to be worth over $600 billion in loan volume per year.
Factoring vs Consumer Credit
The methods behind factoring and risk distribution are problematic. The easiest way to see the issue is by comparing the relationship between a buyer and seller in the consumer space and a buyer and seller in the commercial space. A consumer’s credit is underwritten by a bank. If a consumer buys a sandwich at a store, the consumer gets the sandwich right away. The credit company fronts the consumer money for the sandwich and then charges the merchant a small fee to process the transaction. Within a few days, the credit company pays the store for the sandwich. As long as the consumer pays her credit card bill on time, the transaction doesn't cost her anything on top of the cost of the sandwich.
Credit cards are everywhere because it’s a good deal for consumers and merchants. Consumers get their product right away and merchants get the payment shortly after, which they turn into working capital. Here, everyone takes on part of the risk. The merchant assumes the risk for fighting fraud, the credit company assumes the risk of the consumer paying her bill on time, and the consumer assumes the risk of only making purchases that she can afford. If any party miscalculates on this, they face consequences.
In the commercial space, this process is different. A retailer buys a product from a brand, but asks to receive the product before paying for it. Like buying a sandwich but saying you will pay for it later. This means that the brand now needs to come up with the money to make the product, since they will be paid 30 to 75 days after the store receives the product. To fill this gap, brands often turn to factoring firms, which sometimes ask for 15 percent interest on short term loans. This punishes the brand twice: 1) the brand has to find money to operate and produce the goods, before being paid for them; and 2) the brand has to pay back this money, with interest. The brand is being taxed for taking on risk that the retailer should have assumed. A brand’s 50 percent gross margin can be cut in half after accounting for factoring, a showroom and the additional discounts that retailers extract.
As a result, many brands are operating on financial quicksand, constantly trying to keep up with debt payments while having terrible cash flow. According to “Commercialising Creativity,” a 2014 report by the The British Fashion Council, a fashion brand has to spend money constantly for 10 months until they see the fruits of their labour, at which point they start the process all over again. The chances for a fashion brand to make money organically in this retail landscape are slim.
The Risks of Factoring
The world got a peek at the underlying risk in factoring and the possible fallout in 2009. CIT Commercial Services was the commercial lending arm of CIT Group, one of the biggest factoring companies in the US, with clients ranging from small businesses to multinational corporations like Microsoft. The National Retail Federation estimates that CIT was providing factoring services for 2,000 manufacturers who supplied over 300,000 retail locations, exposing the vast network and reach of factoring. In 2009, CIT Group declared bankruptcy (although the factoring business itself didn’t go bankrupt).
CIT’s finances are highly complex. The money CIT loans out is not its own; it comes from investors and sometimes the government — and CIT’s investors have investors in their own funds. When CIT loans out money that businesses rely on and these businesses pay other businesses with this money, this web of interdependence grows. No one is spending their own money — they are just passing debt around.
When CIT went under, the CFDA issued a memo laying out the problems that might arise for businesses using CIT’s services, and even those that weren’t: “You may find that your factoring arrangement still exposes you to CIT risk, even though CIT is not a direct party to it.” Just as the economy imploded and lost trillions of dollars of value in 2008, if a large player in this value chain, such as CIT, goes under, there is huge potential for a destructive domino effect across the fashion industry.
Informal and Unnatural Social Ties
Consignment is another flaw in the designer-retailer relationship. Consignment means that a brand will give a store its product and only get paid once an item sells. This is the riskiest type of payment term because the brand has to fund all of the cost to produce the product and get it into a store, with no guarantee that it will be paid for its efforts. Even if an item sells, tracking down the payment in a timely fashion is incredibly hard. Sometimes designers have to walk into the shop and confront the owner after seeing the item is no longer on the rack. Even though it is discouraged by entities such as the British Fashion Council and CFDA, stores and some brands consider consignment a necessary evil, like unpaid internships. But it does not need to be like this, with brands hurting while retailers operate largely without risk.
The story of payment terms is a story of retailers preying on vulnerable brands. A prestigious retailer has an audience that a young brand wants and the brand will often bend over backwards to get into that store — even when important retailers push for consignment terms to hedge their risk even more. “On the one hand, you are so happy that they have placed an order, but then they don’t pay you, which creates a chain reaction because you have promised your manufacturers that you will pay them when the stores have paid,” London designer Peter Pilotto told The Business of Fashion. Pilotto says he often fulfilled orders for prestigious stores anyway. While understandable, this practice reinforces the structural flaw in the system.
Retailers are quick to defend practices like elongated payment terms and consignment. “When [retailers] deal with young designers they are taking a risk: they are never sure that deliveries will be timely or that production will be up to standard,” Maria Lemos, who owns RainbowWave showroom in London told BoF. Often, the retailer’s payment terms are the cause of these issues: if the brand doesn't have money to make the goods for a store, it is more likely their order will arrive late, as they struggle to secure financing. Retailers are setting up brands to fail and then shrugging off the blame when something goes wrong.
So how do we fix all of this? There have been some solutions that try to work within the industry structure. The biggest is President Obama’s SupplierPay initiative, which incentivises companies in the private sector to pay their contractors within 15 days. According to the Department of Commerce, paying suppliers faster actually benefits the retailer in the long term. “While faster payment of suppliers may make the [retailer’s] cash flow look worse, it provides working capital for suppliers to invest, which in turn increases supplier quality, innovation and on-time delivery.”
Another option is reverse factoring, where the retailer finds financing for a brand, and then pays it after it has supplied the goods. Proctor and Gamble uses reverse factoring: when the company extended its payment terms for suppliers to 45 from 75 days, P&G worked with banks to offer its suppliers funding options to get paid quicker. Now, a supplier submits an invoice to P&G, and P&G hands it over to the bank, which pays the suppliers promptly. Then, when the 75-day window comes to a close, P&G pays the bank the full amount of the bill plus a very low interest rate.
More radically, brands could unionise and demand better payment terms. The way retailers treat brands today has many parallels to how labourers are treated: low or delayed payment, inconsistent work, unenforced or nonexistent contracts and an unbalanced power dynamic. Like labourers have done in the past, brands could join together to increase their bargaining power. If a dozen coveted brands — with goods that retailers rely on for sales — unionised and demanded better terms, a retailer would have to make some changes. Smaller brands could reap the benefits if some of the larger players took the first step. This is a bold solution, but little changes don't fix structural flaws.
Some say that selling direct-to-consumer is another solution. The general wisdom is that a brand can make more money by owning the relationship with the consumer and, therefore, owning the full margin. But reality is much more complicated. The retailer often has a coveted audience that a brand wants access to. Building this audience from scratch is very hard and expensive. Many successful brands found their audience through a retailer. If a brand pulls out of a good store, there’s no guarantee its audience would follow.
One brand taking these structural issues into its own hands is Navabi, a plus-size fashion e-tailer. Navabi manufactures every piece to order, meaning a consumer pays for the item before Navabi manufactures it. This avoids factoring: Navabi can pay its factory on time, and the factory can then pay its workers on time. “There is no fair share of risk,” Navabi co-founder Zahir Dehnadi said of the conventional industry model. “The customer ends up paying more because the companies need the margin and the company ends up not gaining the highest possible profit.”
Implementing this model was not easy or cheap: manufacturing items to order is often slow or expensive. Navabi had to seek out manufacturers on the verge of bankruptcy or a change in ownership who were willing to try something new. The company also raised $28 million of investment. But Navabi proves it is possible to make structural changes that work in a brand’s favour and improve its bottom line: in 2015, Navabi projected revenues of $88 million to $110 million.
Why This Matters
The prevalence of factoring and prolonged payment terms kills what would otherwise be some really amazing brands. Scott Sternberg’s Band of Outsiders quickly grew from a line of shirts and ties into a menswear and womenswear label with its own stores and the full attention of the fashion press. In 2010, annual revenues were at $12 million. But in 2015 — by which point the brand had raised two rounds of funding — the company defaulted on a $2 million credit line and closed down. The full details around this rapid downfall are murky, but in fashion, “financial difficulties” is often short for factoring and debt.
A brand’s ability to survive is directly linked to how much cash it can pump into its operations. When retailers push risk down the supply chain, it reinforces the flaws in the structure of the fashion industry and, in the long term, works against retailers’ interests. The solutions outlined here are not easy to enact. But fashion is an industry on an uncertain financial footing and all parties, especially the ones in power, should be doing all they can to fix its structural problems. If brands had a solid financial backing and didn't have to rely on band-aids such as factoring, retailers would be able to sell even more clothing, at better prices, to more people. But everybody needs to pull their own weight and manage their share of the risk. Brands are doing more than their part. Now it’s time for retailers to step up.
Richie Siegel is an entrepreneur based in New York.
The views expressed in Op-Ed pieces are those of the author and do not necessarily reflect the views of The Business of Fashion.
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