How To Decide the Percentage for Early Payment Discounts

Are you offering a discount for early payment? It’s a great way to accelerate cash flow, but how much should you discount your invoice? Here’s a simple framework to help you decide.

1. Start with your cost of capital
If you’re considering a loan, invoice financing or revolving credit, compare the discount to the interest rate you’d pay for each of these services. You can compare them by looking at the annual percentage rate (APR). Here’s a list of alternatives.

Credit cards* 1.25-2.5% per month (15-30% APR)
Invoice financing        2-3% per month (24-36% APR)
Revolving credit*,**         1.5-2.5% per month (18-30% APR)

‍*varies based on credit score
**sometimes have additional annual fixed fees
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‍Your monthly discount should be the lowest APR you have access to divided by 12.
Monthly interest rate/early payment discount = APR / 12

(A list of suggested discounts can be found at the end of this post).

2. Consider your profit margins
‍If your margins are razor thin, a large discount can be great for cash flow but really hurt your profit. Try starting with 1% or even 0.5% and increase it if your clients don’t accept the offer and seem to need a stronger incentive. Although it might change over time, decide what you can’t afford discounting beyond and try to stick to it.

3. Review your pricing
Another way to deal with thin margins is to review the pricing and increase it a few percentage points to account for the early payment discount. Think of it as changing your payment terms to be “due upon receipt” and payments after that include “interest rate” that might as well have been late fees (that many choose to never enforce).

                    As an example, an invoice with Net 30 and the amount $1,000 would be discounted 2% for immediate payment, i.e. $20.
                    The customer would pay $980 if they paid instantly, and you would forgo $20 of the invoice amount for that immediate
                    payment.

                    With this thinking, the original invoice amount could be $1,020.41 with the same Net 30 terms as negotiated. If the client                     pays within 5 days, getting 2% off, the total amount due is now the same as we started with: $1,000.

If you have the possibility to increase your prices by 2-5%, you can offer a discount of 2-5% for immediate payment and not forgo any money. If the client wants to pay the original price, they can do that by paying within 5 days.

Please note: There’s a slight difference in the discount and the interest rate. Keep this in mind if you’re invoicing larger amounts or with bigger discounts. In this example, a 2.04% increase in the price is needed to allow the discount to be 2%. For a 5% discount, you need a 5.26% increase in price and for a 10% discount, you need a 11.11% increase in price. You calculate the increase needed by taking 1 minus your discount and divide 1 by your result, then remove 1. 

                    The percentage of the increase = 1 / (1 - your discount) - 1
                    For example, 5% discount: 1 / (1 - 0.05) - 1 = 0.0526 = 5.26% increase
                    For example 3% discount: 1 / (1 - 0.03) - 1 = 0.0309 = 3.09% increase

4. Think about your client’s cash position
Larger companies with steady cash flow might be more likely to pay early for a small reward. On the other hand they might have complex accounts payable (AP) processes where a small discount would not incentivize them enough to push your invoice through faster. Test smaller discounts and increase if they don’t accept it at first.

If your clients have raised external capital, they might be willing to pay early even for a small discount if that increases their margins, which in turn helps extend their runway.

If your clients are smaller businesses or struggling with cash flow themselves, you might need to offer a slightly higher percentage.

5. Test different offers and track results
Try offering 1% for 10 days and 2% for 5 days to different clients and see what gets the best response. This helps you find the sweet spot between speed and cost.

Track when clients pay and what discount they selected in a spreadsheet, or use an early payment discount software that can track the results for you. If you use Cheque for sending invoices with early payment discounts, it tracks and summarizes the learnings for you. There’s no need to commit to a single structure across all clients.

6. Focus on predictability, not just speed
‍
Getting paid early is helpful. Getting paid predictably is better. Even a small discount can be worth it if it helps you plan payroll and expenses with confidence.
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Example of APRs and early payment discounts
Getting paid early is helpful. Getting paid predictably is better. Even a small discount can be worth it if it helps you plan payroll and expenses with confidence.
‍
Example of APRs and early payment discounts

30 days

For invoices that are pushed to be paid 30 days early have the following APRs.

• Net 30 → Due upon receipt
  
• Net 45 → Net 15