I called Mike, who handles our accounting, and he returned the call. Later that day we learned what I had suspected: we were being audited. Supposedly we were “randomly selected”, although I have a hunch that it’s because our second quarter taxes that we had just filed were 1) for the largest amount of income we’ve ever had, and 2) very little of that income was subject to New York sales tax because the majority of our orders are shipped to states other than NY. Of course they’d want to check everything out and make sure they weren’t entitled to a bigger piece of our revenue pie.

They gave us approximately a month to prepare for the audit. It was a lot of work. The auditor needed to see everything. Mike especially had to spend a lot of time reviewing things from years past when he wasn’t managing our accounting.

In the end though, work aside, this actually turned out to be a relatively positive experience for us. We learned quite a bit at a time when we’re still small enough to change things. It also doesn’t hurt that we “won” – New York State ended up owing us a considerable amount of money. No one likes to get audited, but if it has to happen this was kind of the best case scenario.

Anyway, I learned a lot that I think would be helpful to anyone faced with a similar situation.

A Good Accountant is Worth His Weight in Gold

Our first call was to our accountant. We were kind of freaking out. Right away he put us at ease. He told us that a lot of his clients had been audited lately (presumably, NYS, like all other states, is looking for any money they can find, and it’s hard to blame them).

He also advised us that we could give him power of attorney for this audit, moving the location from our warehouse and instead to his office. At no point would we ever have to interact with the auditor. We could just give him everything and he would take care of the rest. We jumped at this opportunity, not only because we knew he’d do a better job communicating with the auditor, but because it wouldn’t disrupt our warehouse operations for a few days.

While he was reviewing everything, he noticed something really big that we had never even considered – we were paying sales tax on our boxes and packing peanuts, but we shouldn’t have been. They are being “resold” to our customers as part of our shipping & handling charges, and are integral to the buying process (the customer can’t get their products without them being packaged). Factor in several years of packing materials, and that’s how NYS ended up owing us money. We’ve since applied for and received a tax exemption from Uline for these materials.

When we first heard that they’d owe us money, we thought it would be in the form of a credit on future taxes. Somehow he negotiated a payment instead of a credit. Again, something we never would have even known about. All in all he was worth every penny and then some! I can’t overstate how important it is to work with a good accountant.

Save Everything

We did get dinged on a few things, although they were more than offset by the credit we received for the packing materials.

The auditor wanted every receipt for every expense to ensure that we had been paying proper sales tax. Despite our best efforts, we weren’t able to dig everything up. I’m as guilty as anyone – there were times when I’d pick up something small like bottled water or paper towels for the warehouse guys, charge it to the company card, and then forget to file the receipt. While it’s still on the books, the auditor has no way of knowing whether I paid the appropriate tax on that sale, and therefore had to assume that we didn’t.

The other example where we owed some money was from online purchases. We made purchases from merchants outside of NY for things like computers where we weren’t charged sales tax. We should have proactively reported those purchases and paid the tax (something everyone should be doing personally as well…although most people don’t).

All in all very minor, but lesson learned going forward.

The Value of This Blog Community

There have been countless times where one of you guys has commented or emailed me in response to one of my posts and either directly or indirectly has helped us fix something we were doing wrong. This audit was probably the biggest example.

Last year on a post about our coupon code and sales strategy, Rob noticed from a screenshot of our checkout page that we weren’t charging sales tax on shipping and the following conversation ensued:

Rob: Is shipping taxable in NY? it is here, so the generally accepted norm is to put the tax after the shipping when presenting the subtotals and totals. If it’s not taxable then the way you’ve got it already makes more sense.

Me: Good question on the shipping. NYS is a small % of our orders…I’ll have to bring it up at our next meeting, probably a question for our accountant given that my googling about it just confused me. George handles paying the NYS sales tax so I’m sure he’ll have some insight too. I’d like to say that we’ve thought it through previously, and we may have, but if we did it was year’s ago and I can’t remember. Update – I decided to look at a few retailers that I purchased from to see how they charged me tax…and it was 50/50. Definitely a question for the accountant.

Me:: A quick update – Rob was correct. We spoke about the tax situation at our meeting. As a group we thought we probably were doing it right by not taxing it, but we asked our accountant and he said that in NYS you do have to charge tax on shipping. We have now changed the site now to reflect that. Thank You Rob!

Rob: Hehe, no worries. Sorry if it’s increased your tax bill!

By proactively fixing that issue we saved ourselves a BIG headache. I’ve never doubted that blogging was worth my time, but if anyone ever did, examples like this really illustrate how it has directly helped our business. Without you guys this site would just be a diary of my ramblings. Big thanks to everyone who takes the time to read, comment, and email.

Is there any solution to this problem? Yes, there is, and we personally know several e-commerce companies that no longer have this problem. Their solution: they have a shit load of cash.

This year we’ve seen good progress towards accumulating that “shit load” of cash. As we keep going further and further above our estimated monthly break-even point, the fixed expenses become more and more negligible and we’re able to profit more and more. Still, the more capital we have access to at any given point in time, the better. You never know when an opportunity will come along where you can put that money to good use. It might be a new line of products, an enticing acquisition, or we might just want to accelerate growth with more marketing or more employees.

Mike took over accounting at the beginning of the year and has made a number of huge advancements.

The largest one, as you can tell by the title of this post, was landing us a large line of credit with our local bank, Citizens Bank. Previously we had a small line with them, and we used that in conjunction with our cash and cards like the (awesome) AMEX Plum to buy inventory. As we’ve become more and more profitable, the need for a larger line has become less and less. Of course, that’s when it became easiest for us to get it. Mike did all of the leg work (it was a lot of back and forth). Ultimately we were able to more than double the size of our existing line. Do we need it? No. Does it change much? No. Is it nice to have it? Hell yes.

This was probably the 10th line of credit we’ve applied for. Here’s a summary of what I’ve learned:

• Banks don’t care all that much about your revenue/profitability. They care much more about assets. If we were unprofitable and smaller but had large valuable houses, or if we owned our warehouse, we would have had a much easier time. Also, inventory doesn’t count as an asset.
• Banks always make you personally back everything. Such is the case with most stuff we’ve done.
• Banks always want the SBA to back their line so that they have even less risk. Everything involving the SBA takes forever and is a total pain in the ass. Thankfully this line was an extension of an existing one so we didn’t need to jump through all of the hoops again.

In addition Mike has made some other huge accounting advancements this year. Learning something new is a big task in and of itself, especially with how busy we all are. Taking what we had and making it much better in such a short time has been really impressive. The simplest was switching to printed checks and double-window envelopes (like these) to eliminate hand-writing of checks, something we had previously been doing. One of those things that saves a few minutes here and there, but compounded over the course of months/years is a drastic improvement, not to mention the elimination of writing errors.

Maybe the most interesting accounting advancement has been his discovery of a little-known feature to automate direct deposits without using a payroll service. Back in ~2007 we used a payroll service for a while and it was a disaster – way overpriced and they messed up a tax filing for us. After that we went to just using regular checks. I had been pushing for a while to get us back to using some sort of payroll service again. It’s a pain for everyone to have to regularly go to the bank. It’s not something that future employees would look at as a perk.

Mike brought it up to our accountant and he mentioned that he had a client using automated direct transfers from business to personal accounts. That’s the tricky part – business to personal. Make that too easy and fraud would be rampant. Mike called our bank over and over again to finally figure out how to set this up. It was a bit of a pain. There are different rules for people who bank with Citizens and for those who use an external bank (there’s a small fee for external banks too). But now it’s all set and we all get our checks deposited automatically…and he doesn’t have to cut a bunch of checks every two weeks. Supposedly most major banks have this feature but most people I’ve talked to had never heard of it like us. It’s not a full-fledged payroll service, but it’s a great option for small businesses like us that don’t need all of that advanced functionality and don’t mind filing our own payroll taxes.

This isn’t all that intuitive of a practice. I mean, you could argue that it’s not worth the effort of even posting it until you have it in stock, have it photoed, and have a description written. Make it a one shot deal. No one will buy it without a photo or description anyway…right? This is what we did in the past, and often times weeks would go by from the time we got the product in stock to when it was on the site.

After the success of the big Meguiar’s pre-sale back in February, we realized just how big of a deal this could be. Many of those Meguiar’s products were sold out before we got them in stock. Meaning we had collected the money from our customers before we were even billed for the products! All of a sudden we’ve turned a huge cash flow disadvantage into a huge cash flow advantage. We can take that revenue to pay off the bill and order more. As opposed to starting off in the red, we’re starting off using our profits to fund growth. By the time that first bill was due, we had already sold out of the second batch of products and had a third (or maybe even a fourth) batch on order.

Of course, that was a major product launch that had a ton of hype in the detailing world. We were the first in the industry to get the products up for pre-sale. We ran a pretty big marketing campaign along with it. We could have just been capitalizing on being first to market and this could have been a non-replicable one-time fluke.

We decided to commit to continuing the practice (and by “we” I basically mean everyone else in the company – my role in getting a new product for sale is pretty minimal, sometimes I’m not involved at all). Somewhat surprisingly it continued to work well across all brands and all types of products. To varying degrees of course, but it always worked. Almost nothing we’ve put up for pre-order hasn’t sold. The craziest pre-sales were some of the brushes we recently picked up. We named them ourselves so they have no prior brand affiliation, and yet people still bought them without a picture or description! When you compound all of this across a bunch of different brands, it has allowed us to expand products faster and with more confidence.

Now, if you’re sitting at home thinking “cool, I’m just going to start an e-commerce business and do this” there are a few caveats worth mentioning…even if they should be obvious. First and foremost, this only works once you have an established customer base that trusts your product recommendations, something you can only achieve with years of good will and honesty, right down from your product descriptions to the information on your site and your customer service. You also need to have a good buyer. Greg has been essentially perfect this year. Everything he’s decided to pick up has been a hit. That only comes with years of experience and a skillset that combines some mixture of good data analysis and good industry foresight.

This experience has been one big lesson in “you’ll never know if you don’t try”. We all hold assumptions about our businesses and our customers. Sometimes we’re right and sometimes we’re wrong. As was the case with the Weekly Special last year, this is one of those times where I’m really glad to be wrong.

Still, we always try to stop fraud in it’s tracks.  Since we don’t ever win a chargeback case after it happens*, we try to stall suspicious orders in hope of having it still in our possession (or in the possession of FedEx) when we get the chargeback .  Until yesterday though, we never actually stopped someone.  Once, Greg we missed calling off delivery by minutes. He then tried calling the customer at the phone number they registered with and actually got someone on the phone, but they denied knowing anything.

Anyway, flash forward to yesterday. We finally got someone. Here’s my best account of the time line:

• Middle of last week a customer places an order for an abnormally large quantity of one product.  His billing address passed verification (meaning that his billing address matched the billing address on his credit card) but of course he was shipping it to another address in another state.  He was smart enough to give the person in the other state the same last name. He also paid an exorbitant amount for expedited shipping.
• Greg flagged it for all of those reasons.  We did have the inventory to fill the order, but it would have left us with next to nothing for the product, so we likely would have wanted to hold the order for a week or two regardless.  He put the order in our “pending” system and shot me an email asking my opinion.
• I replied “Hmm.  His AVS and CSC both matched for his billing address. We could require that he ship the order to the billing address, which would pretty much 100% eliminate the possibility of fraud. When you email him to let him know they’re on backorder you could inquire as to what he’s using them for and if he’ll be ordering regularly so we can stock inventory accordingly.  That might give us a little more insight. ”
• Greg contacted him and he replied quickly (less than a day).  He said he ran a business and was reselling them (which might have been true), and that we could ship it to his billing address, but it would really suck that he would have to then ship it again.  He was trying to guilt us into shipping it out.
• And it worked.  We decided to finally ship it out on Monday.
• Later that afternoon, Greg received an email from someone with the same name as the buyer.  The “real” customer never ordered with us, has had several other fraudulent charges on his card recently, has just canceled his card, and told us not to ship the order because it’s fraud.
• Greg called FedEx and had the package re-routed back to us.  Scammer stopped.

Although we lucked into it in this case, we now have a new policy: large first time orders from people we don’t know must be shipped to a verified billing address. I think requiring this on every order is overkill.  It might even be overkill to require it on every single first order.  But on a big first order that’s not from a legit business this is a more than acceptable policy.

*in that post last year I wrote “Despite being able to provide tracking information to prove delivery for every single chargeback filed against us, we have lost all but one case.” I think I misspoke – I’m fairly certain that I confirmed later on with George that said “win” was a case of “blackmail” where the buyer rescinded the chargeback himself, which does happen from time to time.

Let’s take, for example, a brand new company that’s getting into the blue widget business.  For fun, let’s call the owner Carlos. Widgets cost $50, and retail for $100.  For simplicity, we’ll assume that Carlos has to pay in cash up front (which is somewhat common when you just start out), that he orders once per month, and that he receives his inventory immediately (clearly, not very common).

Carlos has saved up and he has $5k to start out with, so he buys 100x widgets.  In the spreadsheet, Qty is the quantity that Carlos has in stock, COGS stands for cost of goods sold (Carlos’ cost on the items), and Retail is the retail value of the inventory.

Now, 30 days later Carlos is doing pretty good.  He’s sold 75 out of his 100 blue widgets.

Time to reorder!  Since demand is increasing, Carlos needs to spend all $7,500 in his bank account to buy 150x blue widgets. Now he has 175 in stock, but no cash.

Things keep going well for Carlos.  In fact, he’s decided to expand his business into green widgets.  At day 60 he’s down to 50 blue widgets.  He orders 150x again, but also buys in to the green widgets with another investment of $5k for 100x.

Wait a second.  Things are going pretty good, but Carlos keeps spinning his wheels when it comes to cash flow.  When he has a lot of cash on hand, he keeps having to spend it all on inventory to accommodate his growth.  When inventory looks good, he doesn’t have any cash.  He’s profiting, but there’s no profit to spend on anything other than inventory.

Us

Now multiply this over several product lines, with multiple vendors, all of which have different payment terms (cash, credit cards, Net 30), and all of which have various delivery times, and then factor in shipping damages, warehouse space, shelving units, packing material, employees, marketing, and probably 50 other factors, and you basically have us.  It’s easy to see how, despite really fast growth and  lots of cash coming in and out, there isn’t a whole lot left, even if you’re showing a large profit.

The situations that really kill us are vendors that we spend a lot of money with but also have slow lead times, forcing us to forecast out further than 30 days.  For example, we might place an order in July to cover us through September.  We get the products, have 30 days to pay for them, even though we won’t turn the inventory over for several more months.  At which time, we’ll be placing an even bigger order with the same company.  It’s a vicious cycle.

It’s a problem that we’ll probably never rid ourselves of completely.  The interesting thing is that this problem doesn’t stop as you grow.  If anything, it might get worse.  Take the case of Zappos.

The Super Duper Gigantic Company

In an excerpt from his new book, Delivering Happiness, in last month’s Inc Magazine, Tony Hsieh authored an article titled  Why I Sold Zappos.  Essentially, to sum it up for you, the reason was because of inventory:

At the time, Zappos relied on a revolving line of credit of $100 million to buy inventory. But our lending agreements required us to hit projected revenue and profitability targets each month. If we missed our numbers even by a small amount, the banks had the right to walk away from the loans, creating a possible cash-flow crisis that might theoretically bankrupt us. In early 2009, there weren’t a lot of banks eager to give out $100 million to a business in our situation.

That wasn’t our only potential cash-flow problem. Our line of credit was “asset backed,” meaning that we could borrow between 50 percent and 60 percent of the value of our inventory. But the value of our inventory wasn’t based on what we’d paid. It was based on the amount of money we could reasonably collect if the company were liquidated. As the economy deteriorated, the appraised value of our inventory began to fall, which meant that even if we hit our numbers, we might eventually find ourselves without enough cash to buy inventory.

These issues had nothing to do with the underlying performance of our business, but they increased tensions on our board of directors.

The fact that Zappos had these issues is both scary and reassuring at the same time.

Solutions?

We discuss this a lot. It’s probably our biggest growing pain, even more so than hiring, scaling our technology, or developing our warehouse operations. Now, most companies aren’t Zappos, they’re more like us. Is there any solution to this problem?

Yes, there is, and we personally know several e-commerce companies that no longer have this problem. Their solution: they have a shit load of cash. They don’t rely on bank lines to buy inventory. Somewhat of a necessity in the beginning, you can see from Zappos how bank lines can sour quickly based upon factors outside of your control. We’ve also experienced a TON of red tape trying to get new lines or increase existing ones. When the application process involves 10 meetings, personal credit checks, personal tax returns, the SBA’s backing, and a 100 page business plan, you have to question whether it’s worthwhile. Unfortunately for Zappos, they’re too big to solve the problem with cash. They’ve outgrown any potential “sweet spot.”

There are really only two ways for a retail business to get a shit load of cash. 1) You start out with it because you’re rich. 2) You slowly but surely build it up over years and years of profits.

Since #1 doesn’t apply to us, #2 is what we’re shooting for. #2 is how we’ve seen other successful e-commerce companies do it. This isn’t a one or two year thing, it’s a 5-15 year thing. It means absolutely minimizing other expenses (most notably, new product lines, employees and warehouse costs) until that revolving cash flow cycle eventually starts to turn in your favor. If you’re profiting, it will (and if you’re not, well, you’ll be out of business). We see it slowly getting better. The difficult part is controlling expansion – expand too slow and you lose market share, expand too fast and you hit the reset button and start that bad cash flow cycle all over again.

It’s a fascinating topic, one that I think is often taken for granted when starting a retail venture. At first glance, you just wrongly assume that if you’re profiting you’ll have no cash flow problems, which definitely isn’t the case.

Side note: as I’m about to hit “post” I realize that this is my 400th post since switching to WordPress and moving this blog from SportsLizard, where I had another 296. It kind of blows my mind to think that I’ve written almost 700 posts over the last five years. If anything, I suppose it shows I’m consistent when I apply myself to something. Thank you to everyone who has ever read, commented, or emailed!

Being that we’re a bootstrapped company, our work areas are more focused on simplicity and affordability and not so much elegance and creativity. It’s all about setting up areas that get the job done. We need to be able to do our work comfortably without distraction. Nothing more, nothing less.

Here’s what my desk at the warehouse looks like:

A $40 table from Walmart, an old chair from my parents house…and nothing else. Space for my laptop and a few other things. We painted the walls and put in the flooring ourselves.

At home it gets a little more “robust”:

That printer was $99 about 5 years ago and is in dire need of being replaced (then again, I print like 20 pages/year so…). I spent something like $60 for the mesh chair on clearance at Office Max, which is super comfortable on my back. The table is my parents old kitchen table. And the rest of the laptop docking setup, as explained in a bit more detail in my Pimp My Desktop post, was very affordable and is highly functional for what I do.

Some people would look at those workspaces and see a million ways to make them “better.” Thing is, our customers will never see our work area. So when things go good for us we invest in better technology, employees, new product lines, new marketing initiatives, and a little bit in ourselves. Those things matter in our business. The aesthetics of a work area don’t. Now, if we were a financial planning company that had clients meeting at our office daily, it would be a complete 180 – the aesthetics of the website wouldn’t matter nearly as much as those in the office.

If you’re starting a bootstrapped business, every penny matters. You have to be able to identify which expenses are necessary and which ones aren’t.

It’s a common position for potential business owners to be in.  I think a lot of very talented people that would start successful businesses get scared away by the financial uncertainty of starting their own business.

My advice – eliminate all of the uncertainty by using a job to fund yourself. Here’s what I would do if I was graduating today and starting out again from scratch tomorrow:

1. Get a non-career job where you can work 30 – 40 hours/week and make enough money to live off of. It might not impress your parents, but that job bartending or waiting tables or being a barista or bank teller is going to afford you the opportunity to do what you truly want.
2. Pick a potential business idea…then start a related service for under $100. Let’s say you’re like me and want to run lots of successful web apps.  Starting a web app from scratch and building it to a point where it brings in solid revenue is very difficult and many times doesn’t work out.  Instead, start a web design business first.  $100 gets you some business cards, a simple website, and a Skype phone number.  Throw and ad on Craigslist, work Twitter and Facebook, go to a few local networking events, and whatever else it takes to get your first clients for free.   For more ideas, check out my post How To Do Client Work Right that I wrote just after we got rid of the service side of our business.
3. Use the remaining time to work on your “ideal” business. If you still want to build that web app, take advantage of all of the free time that you have to slowly-but-surely build it without the stress of needing it.  Build something that has true value to people, even if it takes a year or two to do it.  The more stress, the more you need a web app to succeed, the more likely you are to press and make drastic changes instead of being patient.  Great websites take years and years to build.
4. Pump profits from your service into growing your “ideal” business. Since you are living off of your job, you can “reward” yourself by spending some or all of your service profit on growing the web app.

Here’s how your average week likely breaks down:  30 – 40 hours working, 15 – 25 hours on your service, and 5 – 10 hours on your ideal business.  ~60 hours is no joke, but it’s also not a bad deal for how much benefit you’re getting.

This is a very low risk, high reward path that gives you TONS of future options:

• If things don’t take off, you can try again or get a career job.
• If the service grows, you can quit your part time job or stop working on the web app.
• If the web app grows, you can stop providing service or quit the part time job.
• If they both grow and you can cover your living expenses, you can definitely quit the part time job!

There are several advantages of taking this approach:

1. There’s no time limit. Totally flop after trying for 6 months?  Start over without any real penalty.  You still have your job so you can take a few weeks off from entrepreneurship and then get back into it when you’re ready.
2. You’re financially stable. You don’t need to worry about owing creditors thousands of dollars because you’re advancing yourself cash to live while the business struggles.  By keeping your business money separate from your personal money, you really do eliminate any real financial risk.
3. By bootstrapping, you learn the importance of every dollar. I love the fact that we’ve never taken outside financing.  We’re pretty minimal in our spending.  We value every single sale we make.  Would we be nearly as stingy if we had $1M from a VC to play with?  Probably not.  We also probably wouldn’t be nearly as efficient or nearly as successful.
4. You keep your motivation. Nothing keeps you more motivated than doing a job that you don’t want to do every day!  That annoying customer who badgers you all night and never leaves a tip?  He’s the reason you work so hard after work.
5. You’re learning constantly. No matter the business you work for, you can learn things.  What do they do that works?  What doesn’t?  How would you do it differently?  You’re getting paid to learn.  Those clients you work with are the same.  To do good work for them, you’ll have to work pretty hard to learn the intricacies of their businesses.
6. You avoid living in a bubble. Running a business solo can be lonely.  I know.  Working a job gets you out of the house, gets you some social interaction, and builds some relationships.  Same goes for doing service work.

My business partners and I sort of did these things, mostly by accident.  I got a job with the intention of funding SportsLizard, but it was a career job and became too conflicting.  Mike and George worked part-time jobs to bridge the gap as they got their start.  Greg was still going for his MBA while he was starting out.  I did SEO service work to keep myself afloat while I tried to grow my websites, which eventually led me to my current partners.  George and Greg did physical detailing to fund Detailed Image.  All along the way, the knowledge we learned from all of those experiences has cumulatively helped us in every aspect of our business.

What is a chargeback?

According to our good friend Wikipedia:

A chargeback is the return of funds to a consumer, forcibly initiated by the consumer’s issuing bank. Specifically, it is the reversal of a prior outbound transfer of funds from a consumer’s bank account or line of credit.

The chargeback mechanism exists primarily for consumer protection. U.S. credit card holders are afforded reversal rights by Federal Reserve Regulation Z under the Truth in Lending Act. U.S. debit card holders are guaranteed reversal rights by Federal Reserve Regulation E under the Electronic Funds Transfer Act. Similar rights extend globally pursuant to the rules established by the corresponding card association or bank network.

A consumer may initiate a chargeback by contacting their issuing bank, and filing a substantiated complaint regarding one or more debit items on their bank statement. Chargebacks are the consumer’s last line of defense against unscrupulous merchants. The threat of forced reversal of funds provides merchants with added incentive to provide quality products, helpful customer service, and timely refunds as appropriate. Chargebacks also provide a means for reversal of unauthorized transfers due to identity theft.

You can see why this would be a good thing.  I’ve encountered identity theft.  Mike and Greg have had fraudulent charges on their credit cards, as has my girlfriend and several other people I know.  They exist to protect the consumer.

But what about when the consumer is wrong?  What if the consumer, not the merchant, is committing fraud? As we’ve found out, pretty much everyone wins except the business.  The consumer gets the charge reversed, and the banks take their money back from us.  Not only are we out the funds, we’re also out the goods that we shipped.  Despite being able to provide tracking information to prove delivery for every single chargeback filed against us, we have lost all but one case.  I did a quick search of my emails and I saw 11 chargeback cases from the past year.  11 times where we shipped the items and (to the best of our knowledge) the items were received by the customer.  And we won once.

Scenario 1: International Fraud

This was the big one, and a large majority of the blame falls on my shoulders.

10/31/2008 – an order comes through on Tastefully Driven for 150 bottles of Glucosamine Chondroitin.  The products total an even $6,000.  Due to an error with our shipping system (since fixed of course), the customer is only charged $35 to ship the order to Singapore, bringing the total to $6,035.  We use PayPal Payments Pro for our credit card processing.  In PayPal, the funds appeared as they normally would.  For international customers, address verification doesn’t work (for domestic customers, we’re able to see if the address on the credit card matches the one that we’ll be shipping to, essentially eliminating the possibility of fraud).  We discuss the possibility of fraud, but agree to move ahead because we know it will take us a long time to get the products in stock.  We figure if we stall long enough and ask enough questions, that we’ll be OK.

11/3/2008 – after shooting a few emails back and forth with the customer, I place an order with our manufacturer for the supplements.  The customer replied to all of my emails, albeit with broken English, and answered a few questions about shipping and the date that he needed the order by.   At this point, we were still a bit skeptical, but the fact that he was in constant communication with us made us feel better.   George called and I emailed PayPal to see if there was anything they could investigate to help us prove without a doubt whether or not this was fraud.  The phone operator basically read PayPal’s chargeback page over the phone, and we never received an email reply.  We were skeptical, but also didn’t have any real proof of fraud.  On an order of that magnitude, we easily make a few thousand dollars, which is probably the #1 reason why we proceeded.

11/13/2008 – we receive the supplements in from our manufacturer, and ship them via FedEx International.  As you can see from the tracking information in that link, it arrived on 11/21 and was signed for someone named “.MR KHAMIS”.  The customer replies back:

Dear Adam,
My order has been delivered.
Thanks for the best product and the best service.
Here is my new order :
- Creatine Ethyl Ester Capsules Size: 120 capsules,qty 400 Btl
- Fish Oil Capsules Size: 100 capsules,qty 200 Btl
Do you have instock ?
Please give me the best discount for the order.
I look forward to hearing from you soon.
Best Regards
Sipex

At which point, we figure that we lucked out and that the order wasn’t fraud.  To be safe moving forward though, we ask for future purchases to be done via wire transfer.  Of course, we never hear back from the customer.

12/8/2008 – we receive a phone call from a lady in Indiana.  Her credit card is brand new, has never been used, but has a charge from our company on it.  Greg took the phone call.  He asked how much.  We were all in the room, and our hearts all stopped when we overheard her say $6,035.  Greg says he’ll get back to her.  We call our lawyer, who is enraged, but informs us we’re pretty much screwed.  Knowing that the chargeback is imminent, Greg calls her back and tells her that she should call her bank to investigate the fraudulent charge.  We wait.

1/14/2009 – we finally receive the notification of the chargeback that we had been waiting for.  We of course file our response immediately, proving that the item was shipped and received.  George calls PayPal again and receives no help…again.

2/23/2009 – almost four months after the initial transaction, PayPal informs us that we lost the case and that the $6,035 has been withdrawn from our account.  We had kept it there all along, suspecting the worst.

For obvious reasons, I want to make sure that I publish this customers information.  Mike researched his address and it appears to be a freight forwarding company, and I’m sure his name/email are fake.  Nonetheless, if someone Google’s his name or address in suspicion, I want them to find this page and read our story.

sipex maboel
Maju Jaya block 1815 geylang bahru
01-05
Kallang Distripark , SG 339716
Singapore
sipex_maboel@yahoo.com

How we’re fighting it:

Because we cannot verify that shipping addresses match the address on the credit card, and because it’s infeasible to take legal action internationally (and to a lesser extent, customs restrictions),  all international orders represent a high risk to us.  We ran some numbers and learned that only about 6% of our revenue comes from outside the US.  After some discussion, we decided to still ship internationally…for now.  We’re taking a very very cautious approach to all international orders.  If an order is over ~$100 and looks the least bit sketchy, we’ve been refunding the customer and requiring a wire transfer.

I’m assuming that Sipex’s success led to us being put on some sort of fraud list, because we’ve had three other similar transactions through Tastefully Driven since that time.  I actually dealt with one a few days ago.  In all of the cases, I immediately refunded the customer, told them that we’d need payment via wire transfer to proceed with an order of that size, and of course never heard back again.  No customer has actually ever gone through with a wire transfer, which reassures us that we’ve probably prevented some additional fraud.

The thing with international orders is that they aren’t critical to our business.  At some point, it won’t be worth the time and hassle to ship internationally.   There is quite a bit of programming work involved with syncing our systems up with USPS for international orders, as well as work involved correctly filing out customs forms.  We’ll piss some customers off, but we’ll make our business more efficient and less risky.

Scenario 2:  Domestic Chargeback Blackmail

These actually bother me more.  Here’s what will happen – a customer will place an order that we fulfill and then change their mind about something and make an unreasonable request.  When I say unreasonable, I mean unreasonable.  We always go above and beyond to correct mistakes or even inconveniences, whether it’s giving the customer a credit, partially refunding and order, or re-shipping an item.  But when sometimes, when a customer demands absurd things, we draw the line.  How do they react?  By threatening us with a chargeback.

They think we’ll give in and acquiesce to their demands.  Of course, we don’t.  And in a few cases, they’ve actually gone ahead and called their bank to initiate the chargeback.  They lie and tell their bank that the charge was fraudulent. We had two of these in less than a month over the holidays where we ended up losing the funds. We decided we had to fight back.  We scheduled a meeting with our lawyer.  He was equally as frustrated as we were.  This stuff is very hard to fight legally.  Also, even on a big order, you have to weigh how much of your time you want to spend hunting down a few hundred dollars.  Then again, you also can’t let people steal from you without consequence.

How we’re fighting it:

We spent a few hours brainstorming with our lawyer the appropriate response.  We decided that he will send a letter to the customer, stating that the order was shipped and received, and that we have proof that the chargeback was initiated as a form of blackmail.  The letter goes on to request that the chargeback be rescinded or payment sent to us, and if we do not hear from them we’ll “pursue to the funds to the fullest extent of the law”.  Depending on the unique situation, we’ll go from there.

I think he’ll be sending our first letter this week.  I have mixed emotions about it.  It’s sad that we need to do this, but if someone doesn’t stand up to people and let them know that this is wrong/illegal it’ll keep happening.

Scenario 3:  Inaccessible Customers

The rest of the chargebacks generally go the same way:  customer files chargeback, we find evidence that the order was shipped and delivered, customer doesn’t respond to our emails/calls, we lose chargeback.  Very frustrating as well.

How we’re fighting it:

Not a whole lot we can do here.  We’ll probably have our lawyer send a letter in these cases as well, but just make it less threatening and more focusing on the fact that we cannot get in touch and to please call us ASAP.

Newegg: the Ideal Model

Newegg has the best possible model.  They don’t ship internationally and they require address verification:

Address verification is a precautionary measure Newegg.com performs to ensure your safety and deter fraudulent activity. The nature of online shopping does not permit us to request a traditional form of identification, such as a driver’s license, like a standard brick & mortar store. We instead conduct address verification through your credit/debit card issuer to confirm your identify and verify the validity of your purchase, ultimately protecting your credit and privacy.

This is the ideal situation.  I think for us, it’s not a question of “if” but rather “when”.  We’d obviously lose that 6% of international revenue, it will undoubtedly increase customer service, and we’ll probably lose some percent of US orders.  It’s a price we’ll be willing to pay for simplicity and security, but not until we’re a little bigger and a little more profitable.

What I Learned From All of This

Flashback to that day when we found out about the international $6k chargeback.  We all let out a few curses, but after 30 seconds we started figuring out what we were going to do about the situation. I called our lawyer, George called PayPal, and Mike and Greg researched international chargebacks.  No one got mad, no one blamed anyone else.  It was the situation we were in and there was no point worrying about things we couldn’t control.  We became focused on what potential recourse we had and what we could do to prevent it in the future.

More than any other event in our company history, this is the one time that sticks out to me as the time I knew I had great partners. Many people would have pointed fingers, and in this case those fingers probably would have been pointed at me.  It’s only when you go through stuff like this that you really get to know people.  You see their true colors and their true intentions, and all I saw in that room that day was a group of people who made a mistake and were trying to figure out what the right thing for the company was to do moving forward.

Mark Cuban tells a great story in his Success & Motivation post:

Then I learned a very valuable lesson. Martin had done a great job of setting up our accounting software and systems. I got monthly P&L statements. I got weekly journals of everything coming in and everything going out, payables and receivables. We had a very conservative process where Martin would check the payables, authorize them and then use the software to cut the checks. I would then go through the list, sign the checks and give them to Renee our secretary/receptionist to put in the envelope and mail to our vendors.

One day, Martin comes back from Republic Bank, where we had our account. He had just gone through the drive through and one of the tellers who he would see every day dropping of our deposits asked him to wait a second. She comes back and shows him a check that had the payee of a vendor, WHITED OUT and Renee Hardy, our secretary’s name typed over it. Turns out that in the course of a single week, our secretary had pulled this same trick on 83k of our 85k in the bank. As Martin delived the news, I obviously was pissed. I was pissed at Renee, I was pissed at the bank, I was pissed at myself for letting it happen. I remember going to the bank with copies of the checks, and the manager of the bank basically laughing me out of his office telling me that I “didn’t have a pot to piss in”. That I could sue him, or whatever I wanted, but I was out the money.

I got back to the office, told Martin what happened at the bank, and then I realized what I had to do about all of this. I had to go back to work. That what was done, was done. That worrying about revenge, getting pissed at the bank, all those “I’m going to get even and kick your ass thoughts” were basically just a waste of energy. No one was going to cover my obligations but me. I had to get my ass back to work, and do so quickly. That’s exactly what I did.

When you get taken like we did, all you can do is get your ass back to work.

After my subsequent post about how we saved $1k in FedEx charges with the Plum, AMEX contacted us and asked if they could feature the content of the post in their new online marketing campaign.  We didn’t know exactly what to expect, but per Mike’s post earlier today it appears as if they used a quote from that first post on their Plum card website:

Pretty cool.  Thanks AMEX!

Now, if we could just be featured in a commercial…

A few weeks back Penelope Trunk wrote a really interesting article about deciding where to locate your start-up, entitled Starting a company in Silicon Valley is stupid.  Clearly from the title of the post, she isn’t one of those people that preaches that you have to be in the Valley or in NYC to run a successful start-up.  She herself moved from NYC to Madison, Wisconsin to start her new company, simply because the cost of living was low and the quality of life was high (according to studies on that sort of thing).

A couple of my favorite quotes from the article:

“The beginning of a company is slow and meandering. You have pretty much no idea what the company is or what you are doing with it, or if you even picked the right partner to do it with. During this time, it does not matter where you live. You are not hiring. You are not pitching your business because you don’t have a pitch.”

“Most of you will not be going after venture capital. You simply will not have a business idea that warrants that kind of investment. And in that case, you will be bootstrapping for a long time. And it’s a lot easier to bootstrap in a place with a low cost of living. And if you are not going to take in venture capital, then you don’t need to be where the big VCs are: New York and California”

“You don’t need your network in your backyard (which you would have automatically if you lived in Northern California), [but] you do need to be able to fly to your network frequently. The network you can build by just showing up in California or New York is unprecedented.”

All of this got me to thinking – is Albany, NY the best spot for Pure Adapt, Inc?

The answer I came up with was yes, and surprisingly our home town is actually a pretty good spot to start a company like ours.  Here’s why:

• Our networks are here – all of us grew up in the area.  You take for granted all of the people you know in your home town.  When we fired our accountant and needed a new one, we were able to get more referrals than we could handle because we knew so many people in the area that were small business owners, either through family or friends or former internships or former jobs.  Albany also has a lot of great higher education, and between the four of us we attended the four largest schools in the area.  George and I went to RPI, Mike went to SUNY Albany, and Greg went to Siena undergrad and Union for his MBA.  The connections we made there have opened up a lot of doors for us.
• A steady economy supported mostly by government and education – being that Albany is the capital of New York State, and that New York State is a pretty big state, there are a ton of government jobs in the area.  I don’t know one person who doesn’t have a very close friend or family member that works for New York State.  Every one of my friends who lives in the area that isn’t a part of Pure Adapt has a state job.  My father is a programmer for the NYS Health Department.  That’s just how it is around here.  In conjunction with eduction, this creates a very consistent economy that doesn’t boom or bust like the rest of the country, and that’s a good thing for a start-up like us.  With steady government jobs come all of the resulting steady jobs at hospitals and resturants and the like.  The recession has affected us here, but not nearly like it has in other parts of the country.
• Available talent - having such a large academic community is a huge advantage for us.  You always hear people around here talk about how top students come to school here and then leave to go to the big companies in Boston and New York City and Connecticut.  From my experiences at RPI, this was definitely true.  When I was doing interviewing for internships and full-time jobs in our career center, I don’t ever remember seeing companies from Albany.  I do remember companies from pretty much everywhere else.  I can think of a handful of companies from Silicon Valley that came to RPI to recruit tech talent, but no local companies.  While this might not be a good thing for the area as a whole, it can be a very good thing for us.  There is plenty of talent at these schools that would probably prefer (or at least consider) living in Albany post-graduation if there were options available.  We plan on being that option, and we don’t think there will be all that much competition.
• Albany is a “crossroads city” - roughly equidistant from NYC, Montreal, Boston, and Buffalo, you can get to a lot of different places in just a few hours drive.  I can hop a train and be in Penn Station in NYC in about 2.5 hours, eliminating the need to fly to get to a major networking hub. If I needed to get down there a few times a week for networking or meeting with investors, I could.
• Albany is a pretty big city - according to Wikipedia, Albany is the 56th largest urban area in US.  As you can see from the picture, the city isn’t exactly small.  Although commonly dubbed “smallbany”, it has pretty much anything that any other US city has, short of Boston or LA or NYC.
• Everything costs less - according to Salary.com’s Cost of Living Wizard, someone making $35k in Albany would have to make $55k in San Fransisco to maintain their current standard of living because the cost of living is 55% higher, and businesses typically pay only 20.4% more for the same job to compensate for that increase in cost of living.  Simply put, our money goes further.  We can pay ourselves less, we can pay employees less, and things cost less (real estate in particular).  All of this adds up to a lot of money saved for e-commerce company that, from the perspective of our customers, could really be located anywhere so long as they ship products quickly.
• It’s spacious here - when I lived in southern Connecticut, about 45 minutes from New York City, the population density was insane.  People routinely commuted up to an hour and a half to work just to find affordable living that wasn’t in an urban area.  In Albany, my apartment is less than a 15 minute drive from downtown Albany, but also less than 15 minutes from some amazing nature.  If you want to live on a farm and commute downtown, you can do it and have less than a 30 minute drive.  Or you can live somewhere like Lark Street that has a big city downtown feel.  This spaciousness is the reason that we got our warehouse space so cheap.  We’re not in a bad neighborhood or a long drive away, but we got space at about 1/5 of the cost of what it would be just 20 minutes away in downtown.  Personally, my commute is about 12 minutes on back roads, which doesn’t really feel like a “commute” at all.

Now, from a personal standpoint, I do want to experience and live in other places.  The few years I spent in CT were awesome.  In a few years I hope that our business gives us the freedom to do so, but in the meantime this isn’t a bad place to live.  You really can do everything except hit the beach or watch professional sporting events, but those are only a few hours away.  Aside from Albany, other cities like Schenectady, Troy, Saratoga & Lake George are just short drives away.  And yea, winter sucks here, but I try not to be one of those people who always thinks that the grass is always greener somewhere else.  There are a lot of great places to live, but we certainly lack nothing important here.  So until the company is sold or I’m removed from the day-to-day operations, I’ll be happy here.

Ultimately, Albany works great for us.  In most cases you don’t need to change your location to start a successful business, and certainly don’t have to move to New York City or Silicon Valley.