Using Factoring / ABL Lenders – Borrower Beware

During the last several months, the number of small businesses turning to commercial factoring and asset-based lending companies (ABL) has dramatically risen. This is occurring as local banks are pushing line of credit borrowers out of traditional lines of credit.

Factoring companies are private commercial lenders that finance accounts receivable from businesses that sell to other businesses. ABL lenders loan to larger companies and often include inventory financing into their loans.

The use of factoring and ABL lending is a viable and often good way for a business to gain access to working capital. Many borrowers prefer to work with such lenders rather than traditional banks in good times as well as bad because of flexibility and ability to grow faster.

There are more than a thousand factoring companies in the United States. Some specialize in vertical markets such as construction, temporary staffing, and foreign receivables. Most of these companies are reputable and give a high level of customer service. However, there are some that use unscrupulous practices that can hurt a business borrower or even put them out of business. Borrowers considering factoring and asset based lenders should ask for recommendations from other businesses. You should not assume that all commercial finance companies are created equally and it is important to do as much due diligence on a lender as they do on you and your company.

Perhaps the most important thing a potential borrower should do is fully read and understand the legal agreements before signing them. This will allow you to go into the transaction with your eyes open. Many of the terms and conditions are negotiable, and when terms are simply unreasonable, you can stop the process and look elsewhere for your working capital.

Yesterday, I read the very worst factoring agreement I have ever read. The borrower is a small Texas temporary staffing company. The factoring company is based in North Carolina. The borrower has never had any face to face meetings with anyone from the factoring company and the transaction began after a telemarketing call from the factor to the borrower. When the original agreements were signed, the borrower needed a small amount of funds for payroll and thought the call from the factoring company was timely.

Apparently the borrower never read the legal agreements before signing them, because if they did, they would have run the other way.

The factoring fees being charged seem reasonable to me for the amount being financed, which is where unscrupulous factoring companies tend to hurt companies the most. It is the agreement termination provisions that give me serious heartburn.

Now the small Texas staffing company is about to grow from less than $1 million in annual sales to over $5 million. They now need better customer service and lower rates but have no ability to negotiate with their existing factoring company because they are locked in.

Many factoring companies want you to commit to them for a year and many of them have automatic renewal provisions if you don’t give 30 days notice of your intent to not renew the agreement. Many of them have early termination penalties if you cancel the contract early. Often these conditions and fees can be negotiated away completely or reduced substantially if you do so before you sign the agreement. Once you sign the agreement, your leverage is gone.

In the case of the agreement I read yesterday, it required a 24 month base agreement with 18 month automatically renewing terms. In my 15 years working with companies in the factoring environment, I have never seen a factoring company ask a very small customer for such a long commitment, but that wasn’t the worst part of the contract.

The contract I read yesterday had several completely unreasonable provisions. First, the contract required the customer to give 90 – 120 days notice of its intent not to renew the contract before the 24 month contract or each of its 18 month extensions expired. The real insult was that complete payoff off of the outstanding balance is due in full with the termination notice. The contract did not provide for any early termination penalties, which would have at least provided the borrower a known fee to exit the relationship.

Instead, this contract had provisions allowing the factoring company to wait the 90 – 120 days to terminate its UCC Financing Statement which is a public document informing other potential financing sources that it has rights to collateral. A UCC Financing Statement (called a UCC-1) is filed in the county and state the customer is located. It is very difficult and sometimes impossible for another lender to step in and finance a customer as long as there is an outstanding UCC-1 filing in place.

In the case of this temporary staffing company, that means they can’t finance their payroll after they terminate their agreement with the current factoring company until the 90 – 120 days has passed and until the UCC-1 is released. This essentially puts the staffing company in the position of not having financing for 90 – 120 days. For many staffing companies that means going out of business.

My assumption is if the customer calls the factoring company and asks to be released from the contract, the factoring company can name any price it wants to terminate its UCC-1. Or as the contract provides, it can simply not terminate the UCC-1 for 90 days.

I am not an attorney, but I suspect this agreement is legally binding. The customer should have read the agreement BEFORE SIGNING IT and if they didn’t completely understand it, they should have consulted an attorney. In the end, the staffing company should have looked elsewhere for a financing source.

I have designed a checklist of the most common types of fees and contract terms that are used in the factoring industry. Feel free to download this document and use it to help you make your decision about your prospective factoring company’s method of doing business.

The good news is there is tremendous competition in the factoring industry and rates and conditions are reasonable across the marketplace, but borrowers still must be careful about who they do business with.

Sam Thacker is a partner in Austin Texas based Business Finance Solutions.

You may contact Sam directly at: sam@lesliethacker.com

or follow him on Twitter: SMBfinance

EXTRA: If you have questions for Sam regarding business financing, the credit market, and similar issues, please send an e-mail. Your questions will be recorded and Sam will answer the best ones in his podcast show.