Companies often turn to a type of working capital financing called “factoring” when the following conditions exist:
- Their primary credit sales are to other businesses; and
- They are very fast growing; and/or
- They have large opportunities that can’t be financed by internal profits; and/or
- They have had uneven years of profitability and retained earnings; and/or
- Their business is cyclical or seasonal.
Factoring, (or accounts receivable finance) is a very old type of financing which began 4,000 years ago in Mesopotamia. During the early American colonial period, factoring was an instrumental financing method when fur and lumber traders shipped goods to Europe and couldn’t wait months to be paid.
In the United States factoring is the primary method of financing certain industries such as textile, garment, furniture manufacturing, temporary staffing and transportation. During the past 15 years, small businesses have had access to factoring as a way to finance unlimited growth for service companies, manufacturing concerns, wholesale distribution, and other companies experiencing uneven or rapid growth.
When a client business uses factoring for working capital, the lender or factor strongly considers the creditworthiness of the client’s customer (also known as the debtor) more than that of the client being financed.
Financing is obtained when the client borrower “sells” an invoice or batch of invoices to the factor at a discount. The discount is the fee the factor charges for advancing 75 – 90% of the face value of the invoice at the time of sale. The amount being held back is called the factoring reserve. The discount fee amount is normally based on the number of days from the advance of funds to the collection from the debtor. Once the invoice is paid, the client’s obligation to the factor ends, the factor receives its fees for financing the transaction, and the excess collateral or reserve is returned to the client borrower.
An example transaction is shown below. In this example, the factor charged 1.25% for each 15 days of the transaction and the debtor paid within 15 and 30 days. The advance rate was 80%.
Total amount of invoices being factored:
Factoring reserve (20%)
Amount advanced to client day 1
Factor’s discount fees (for 30 days)
Reserve returned to client day 31
The greatest benefit of factoring is accelerating cash flow from the normal payment cycle to the one or two days it takes to process a batch of factored invoices.
Often times this acceleration of cash causes the client borrower to change from thinking like a cash poor business to a cash rich one. Thinking like a cash rich business often allows a creative business owner to negotiate cash discounts from its vendors, make strategic forward buying decisions, and most importantly keep a higher amount of safety money on hand. There is nothing quite as strong as having a large cash balance in the bank to keep a business healthy.
Creative business owners can often pay for the cost of factoring though better buying, and by passing on some of the cost to their customer.
Terms used in the factoring industry include:
Full recourse factoring. Simply put, if a debtor doesn’t pay within a certain number of days past terms, the client borrower must buy back the invoice with reserve funds kept by the factor. This is the most common type of factoring for small businesses. The client borrower maintains the credit risk, though the factor often does serve a valuable service by performing back office credit investigations on behalf of the client borrower.
Non recourse factoring. When a factoring company buys an invoice with no recourse, the factoring company assumes all credit risk. This means if the debtor doesn’t pay, the factor has the obligation to pursue legal recourse against the borrower. Non recourse factors don’t necessarily charge more for assuming the credit risk, but can often be more careful about which debtors it will buy invoices for. Neither full recourse factors nor non recourse factors assume risk associated with dispute over quality of goods and services rendered.
Nearly all factors require the unlimited personal guarantee of all 20% or greater shareholders, however, in cases where the company doesn’t have a single large shareholder, factors will sometimes substitute a validity guarantee for the unlimited personal guarantee.
Most all factors require the debtor to be notified of the factor’s interest in the payment stream and nearly all factors require payments to flow through their lockboxes or bank clearing accounts.
Factoring has become a very mainstream way of financing working capital and fast growth. However, one must be very careful when choosing a factoring company to do business with. I have designed a Factoring Comparison Worksheet which helps business owners compare the fees and terms of doing business with a factor. Even though most factors are good and honorable companies, there are a few unscrupulous companies that you don’t want to do business with.