I have never had a perfect method for setting aside the money we owe consultants. When times are good and cash flow is good - no problem. Other times, you can find yourself in an unexpected hole with no simple way to get out.
About five years after I started my firm, our work completely dried up. We were down to just two of us and a major debt we owed our consultants. Ultimately, I talked to each one and told them of my problem (theirs too). I asked for time and promised to make some small payment every month with the full intention to pay off everything that I owed.
During this time, in order to follow thru, my take-home pay was about $10,000 a year. You want to steer clear of this pitfall. How?
So here is how the pitfall develops. When you get the bill for your consultant's work, but you haven't been paid yet, you set the bill aside until you get paid by your client. Agreements with consultants normally have a 'Pay when paid clause'. So far so good. But when the economy goes south or your own backlog begins to peter out, you often find that your cash flow is deteriorating too. You go to pay bills when the payment from your client comes in and there isn't enough money to cover everything. Lots of bills look more critical than paying one or more of your consultants.
If you can't afford to pass along the money owed to consultants when you are paid, then you have just embarked out onto the slippery slope. I find that it gets harder, not easier, to catch up as time goes on. Past experience has taught me that this is when adjustments have to be made to expenditures. Unfortunately payroll is usually the only item large enough to make a difference. If you don't have a candidate for a layoff, I have sometimes decided to 'share the pain' by cutting everyone's hours across the board. Other times the principals have contributed cash to get things straightened out if the problem looks very temporary. If the shortfall can be corrected this way, it is a better solution, because cutting hours means that there will be less billable work and less income down the road - the exact opposite of what you need to get off the slippery slope.
This is one of the ways that profits are necessary - you need a rainy day fund for situations like this. Borrowing money from the bank doesn't solve this problem, it just changes the creditor.
So what is the big picture solution? I suggest that you set aside profits every year and pay your consultants from that account if necessary. The real problem though is recognizing that you have a money problem that needs a solution, usually by making some changes as suggested above.
I suggest that 10% - 20% of your profits every year should go into this savings account earmarked for a rainy day so that you can self fund any issues that pop up. Think of it as investing in the financial health of the firm. It will take a few years to accumulate enough money to be helpful, so the sooner you start the better. Don't worry about how much money should be in the fund. When problems arise, it will never be as large as you wish it was.
You have been warned about this pitfall, so take action now, and stay on the alert.
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