The financial collapse of FTX may seem like a distant concern since the mostly unregulated industry is different from software, e-commerce, manufacturing, or services. But the heart of FTX’s strategic error – using customer funds to pay for risky business bets – exists throughout the small business community.

Many entrepreneurs do not even realize they are doing it. The strategy lurks in the working capital section of balance sheets and cash flow statements, where many managers do not know to look. As a fractional CFO, I see it all the time, usually when a new client comes to me in a state of financial distress. FTX is now accused of ethical violations. Are you at risk of committing the same ethical errors?

Customer financing in business

FTX used their customer’s deposits to place risky bets for profit. That strategy works when everything goes according to plan, but it’s a house of cards when something unexpected happens.

Using customer deposits and prepayments to fuel business bets exists in nearly every industry. Here are some scenarios:

  • SaaS deferred revenue

A SaaS company offers a 20% discount to pay for the year up-front. The SaaS company uses these deferred revenues to invest in advertising and sales but fails to generate a healthy return. Seven months later, the company goes bankrupt and can not refund its customers.

  • E-commerce backorders

A celebrity releases a limited-edition gym shoe. One reputable online store offers pre-orders for $1,500 each and sells out quickly. Several months pass, and the customers have yet to receive their shoes. Some apply for refunds only to discover the company’s cancelation policy is punitive and unreasonable. Eventually the company declares bankruptcy without giving any customers their money back. (Inspired by this true story.)

  • General construction mis-bid

A general contractor (GC) bids on a big construction job that pays 50% upfront for materials. Supply chain constraints and a tight labor market crush the GC’s budget, creating delays and cost overruns. Faced with a financial impossibility, the GC walks off the job, leaving the customer with a half-completed project.

All three small businesses used customer deposits (a liability) to fund some risky bet – a construction job, a rare new sneaker, or growing the core business. To be clear, these are not bad business strategies. In fact, the GC, crushed by macroeconomic forces, was mainly just unlucky. Nonetheless, each was a betrayal to the customers who did not explicitly consent to the risks taken with their money.

The Ethics of Customer Deposits

If you are taking deposits or prepayments from customers, you have an ethical responsibility to soundly manage your business’ financials. Here are my top 3 tips to make sure you are behaving ethically.

Know your working capital structure: You must know your working capital risk by knowing your balance sheet. Consult a financial advisor if you have doubts about your working capital knowledge.

Know your regulations: Real estate, title, finance, and attorneys must maintain separate accounts for customer deposits. Take time to know which regulations apply to you and invest in accounting resources to maintain accurate records.

Forecast monthly: Use an operating forecast to project cash flow, test scenarios, and avoid crashing the business. I recommend running through “disaster planning” once a year so you are familiar with the signs and symptoms of a downturn and can respond accordingly.

Do not kill the golden goose: Successful entrepreneurs often chase new ideas with zeal at the expense of existing and profitable businesses. Never bet the house on a new product, service, or market. For a bootstrapping company, avoid investing more than 20% of your revenue into R&D or growing a new market.

Prepare backup capital: Be prepared for emergency funding if needed. You cannot secure new financing during distress, so you should prepare capital sources during the good times. Options for small businesses include:

  • Business lines of credit
  • Owner personal funds and contributions
  • Assets that can be sold quickly

Know when to pull the plug: Sometimes the most responsible thing you can do is fold the business before the damage becomes too great. Set clear limits with your management team about when the game is lost. Examples include:

  • We will not incur more than $x in debt
  • We will close the division if volume drops below X units per month
  • We will quit that project if we cannot hit the deadline by xx/xx/xxxx

Keep your stakeholders in mind: Remember that your business has more stakeholders than shareholders. Financial management is an ethical responsibility for all entrepreneurs. If your business is running out of cash or you are unsure how to manage working capital responsibly, ask for help now. It is your ethical duty.

By LJ Suzuki, Fractional CFO