Small Business

Peer-to-Peer: How does factor financing work?

Written by PROFIT-Xtra

Question

“I’m having problems financing the gap between sending out my products (and paying my staff) and getting paid. A friend suggested factoring as an option. I’m not sure I understand the concept completely. Can anyone shed some light on what it is, the plusses / minuses and where I can find more information?”

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Reader responses

Rob Bennett, Municipal Software Corp., Victoria

We used factoring quite successfully for a period of about 18 months in 1998 and 1999. Dealing with exclusively local government agencies, our receivables were always ‘good’. About 18 months into our relationship, however, a change took place that caused us to stop using factoring as a financing mechanism.

For the first 18 months we had worked out an excellent relationship with the factoring company. We would invoice our client, and send a copy of the purchase order (or contract) along with the invoice to the factorer. They would advance 98% of the invoice amount and deposit it directly into our account. We received the payment from the client, deposited it into our account, and called for a payout. We would then deposit the payout (along with interest accrued at the rate of about 10% per annum). Normally we would receive payment in 30 to 45 days, and so it all worked like clockwork.

The factorer’s Board of Directors then changed, and they decided that a change in policy to reduce the firm’s potential exposure was required. They moved from ‘soft notification’ to ‘hard notification’. Our relationship was considered ‘soft notification’ — we invoiced the client and then the client paid us directly. They then required ‘hard notification’ which meant that the client had to be informed that the invoice had been ‘sold’ to the factorer, and that payment had to go directly to the factorer. Worse than that, they could contact the client directly from a collections perspective.

We understood that in many industries this is acceptable practice, but in the high technology sector, and in the local government industry, we felt that this would be setting off alarm bells all over the place. Our customers are very important to us, and to wave what could be construed as a big, red flag in their face, and then to let another company call ‘on our behalf’ was not acceptable to us. Though the transition was slightly painful from a cash flow perspective, it was still the best decision for us to make.

We still think that this is a fantastic form of financing, as long as all of the terms and conditions make sense for your company and your customers. Be sure to read all of the legal fine print to be aware of all of your obligations, and activities that a factorer may perform ‘on your behalf’. If you can find the right group to work with, factoring can definitely help you to build your business!

William Elliot, DNA Capital

The word ‘factor’ comes from the Latin factare meaning ‘to make or to do’. This financing mechanism dates back to the time of Hammurabi and has been part of the basic fabric of all trade.

The concept of ‘making it happen now’ continues. Essentially it is the sale or assignment of a sale, trade, or accounts receivable account for immediate cash. By definition, it provides any business from start-up to mature companies (at any size), access to immediate cash and improved cash flow for expansion or growth but without diluting equity or incurring debt.

Advantages of factoring:

  • Fast and easy to set-up
  • Improves cash flow
  • Leverages off your customers credit
  • No consideration of your business’s credit rating
  • Continuous source of operating cash
  • No long term contracts
  • No personal guarantees
  • Faster payment
  • No debt creation — no monthly or balloon payments
  • No geographical limitations
  • Can be used to replace foreign receivable insurance
  • Comprehensive credit service support
  • Credit screening & monitoring
  • Early detection of customer service problems
  • Detailed management reports
  • Professional collections
  • Reduces overhead — can replace in-house credit management
  • Greater operating efficiency
  • Off balance sheet financing
  • Provides “time value” of money
  • Retain control of your business — do not give up equity
  • Reduces bad debt
  • Offer credit terms to customers
  • Meet increasing sales demands
  • Stop offering early pay discounts
  • Flexibility — factor one or as many receivables as you wish
  • Take advantage of trade discounts from suppliers

The essence of the transaction is the credit worthiness of the particular receivable account. Regardless of stage of development (even in bankruptcy), immediate cash may be available.

Factoring is not a collection system for bad debts or even slow pay accounts. Use of factoring may, however tend to speed the payment from an otherwise slow-pay client once the disciplined payment techniques of a qualified factor are introduced. As with any ‘financial tool’, there may be wide variations in applicable terms, conditions, and cost rates for its utilization.

For example, advance rates (percentage of invoice paid in advance of collection) may vary due to account risk, industry, and factoring firm. The discount rate (fee charged by the factor for the financing) may also vary by actual risk in the account, industry, and / or factor firm. Transactions may either be ‘recourse or non-recourse’ (return liability or guarantee of collection from the firm) which may take the form of merely replacing a receivable if it reaches a previously agreed upon age.

All of these variables then come together in a ‘risk evaluation’ cost rate or fee for the factoring service. As with any type of financing, the greater the perceived risk, the greater the cost for the service. The range for the first 30 days might be expected to be 2% €“ 7% of the gross value of the account financed, with 5% being typical.

There may also be a wide variety of other terms and conditions in the transaction such as:

  • Minimum invoice amounts (i.e., $200 €“ $500), minimum monthly volumes (i.e., $10,000 €“ $500,000), and / or time period commitments (i.e., 6 €“ 12 months)
  • Notification and non-notification to the receivable account that a factoring transaction has occurred

Just like all financing options, the business firm must evaluate its own individual needs and requirements including a focused evaluation of all actual or potential advantages versus the costs in the transaction. In most circumstances and at every stage of development, factoring, if properly utilized, can be a very valuable financial tool to achieve expanded sales and company growth.

Not all factoring companies are alike, often with wide variations in terms, conditions, and rates depending on your firm’s needs and accounts receivable (as well as size and geographic coverage — local, regional, and national, international).

The use of a Business Finance Consultant will allow you the expertise of choosing from number of financing options and financial companies to suit your company’s needs. There is usually a ‘no charge’ consultation for new companies to allow the consultant the opportunity to assess your needs and the effect your borrowing requirements may have on existing financing already in place. The consultant has a funding relationship with several lenders and will know which lender best suits your requirements as well as the type of financing which is most appropriate for the transactions required. The Business Finance Consultant will not usually charge you a fee as they are paid a referral fee from the Lender.

Edward Trecartin, Quispamsis, NB

Factoring is a situation whereby a company (i.e., you) would either sell your receivables to a third party, or use your receivables as collateral in order to obtain loans / financing giving you quicker access to cash, therefore shortening your operating cycle. This is done on a discount basis, meaning the third party will for instance give you 85% of the value of your receivables.

There are many different arrangements in factoring that can be made and I will only touch lightly on the basics to provide a better understanding:

Factoring without Recourse: This is when you sell your receivables to a third party (a factor) who assumes legal title to the receivables as well as the cost of uncollected accounts (customers failing to pay) and the general collection responsibilities. You get the money and go on your merry way.

Factoring with Recourse: This is basically the opposite whereby you maintain legal title of the receivables; have to collect the money from your customers, etc.; and assume all the risk with any uncollected accounts. This is more of a loan (payable on your books) whereby you would pay the third party the money you collect.

Using Receivables as Collateral: This is just like any loan agreement with a bank — for example whereby your receivables would be used as collateral in the event you did not repay your loan.

The above agreements can be done on a notification basis (customers are told to remit payment to the third party) or non-notification basis (you continue to collect payments on the third party’s behalf.)

There are only a couple of real benefits to factoring:

  • Money to shorten your operating cycle, that is having money up-front to pay all your costs.
  • On a non-recourse basis you do not have to worry about collecting from your customers.

The negatives to factoring are:

  • You only receive a discounted amount of the value of your receivables. The amount received will depend on the third parties perceived risk. The greater the risk the less money you are going to receive.
  • On a recourse basis you assume the risks of collecting. Therefore if a customer does not pay you still owe that money to the third party. On top of the discount for your receivables you lose more money.
  • On a non-recourse basis you ultimately lose some control over your business, as the third party basically takes over control of your accounts receivable. If this is a long-term agreement it will be they who decide to extend or not extend credit to [a customer].
  • If the factoring agreement has customers remitting payments directly to the third party, it may be perceived from the customer that you are in financial distress. Not generally good for business if a customer thinks that you could go bankrupt anytime. They may start to shop around for a new supplier.

Finally, the best source of information would be to talk with an accountant. They would be able to explain this much better face to face. They can perform, for example, a cost / benefit analysis to determine if you should factor or attempt to obtain a line of credit to make up the shortfalls. For example, if the time you have to pay your operating costs to receiving payments from your customers is only 2 weeks then a short line of credit would work just fine. In any regard an accountant would be able to perform the benefit analysis after obtaining a better understanding of your finances and operating cycles. There are, to my knowledge, not many business books written on factoring, except in accounting textbooks and the like.

David Petrie

When you factor your receivables, you sell them to another firm (the factor) at a discount, in the interest of getting the money today. Your customer then pays the factor directly. For instance, I purchase $1,000 worth of your products on credit today. Because of your prior agreement with the factor, they pay you a discounted amount (say $950) today. Your invoice to me instructs me to pay the factor directly.

The biggest plus is that you get paid immediately, which certainly helps cash flow. As a consequence, you are also spared the hassles of collections and bad debts.

On the down side, you don’t receive full value for your accounts. In my example, I suggested a 5% discount; when you contract with a factor, they will look at the quality of your receivables, your collections and bad debt experience, and base the actual discount on their analysis. It could easily be higher than 5% (the discount is how they make their money). Thus, if you have slim margins, they automatically get slimmer. This may not be that attractive.

Secondly, some companies may look at your use of a factor as an indicator of financial problems. This can have several consequences: they may choose not to do business with you if they feel you won’t be around for the long haul; they may delay payment to the factor unduly, thus worsening the factor’s credit experience with your accounts and driving up your discount rate; they may use the knowledge of your cash-flow ‘problems’ to drive a harder bargain with you on subsequent sales.

Thirdly, you have probably developed a method of dealing with delinquent accounts, and this method may be a good deal gentler than that which may be used by the factor. In fact, the factor, who doesn’t want to be out its profit any longer than necessary, may strong-arm any delinquent accounts. This may discourage those accounts from continuing to do business with you.

Given these issues, I would suggest you explore receivable financing with your bank or financial institution in preference to factoring. If you have real estate, you may want to arrange an operating facility (line of credit) secured by a collateral mortgage; if you deal with a bank, they will set up a line of credit for the difference between any outstanding mortgages on the property and 75% of its appraised value; banks prefer not to exceed 75% of value. The collateral mortgage means that, as long as you are not in breach of your loan agreement, the line of credit operates as usual, but, if you breach the agreement, you automatically have a second mortgage in the amount of the outstanding loan.

If this is not an option, look very carefully at any factoring arrangement. As with any major purchase, talk to people who have used the service before. Talk to your factor’s collections people. Read the contract closely. Discuss the matter with your larger customers before you enter into a contract. Make sure they know this is not a sign of undue financial weakness, but simply a method of accelerating cash flow. Perhaps they can arrange to pay you earlier.

In any case, good luck, and be careful — most short-term financing arrangements present opportunities to act in haste and repent at leisure, so be sure you aren’t stampeded into doing something you will regret later.

Ken Steele, steelecommunications inc., London, Ont.

In the distant past, we thought factoring was an attractive option to improve cash flow and allow us to sustain rapid growth. In order to factor a receivable, though, your client’s credit history must be spotless, and will be investigated. And you’ve got to be willing to give up 10% of the invoice — which could be more than your profit margin, in which case the decision is a very dangerous one.

The other major problem with factoring receivables is that most factoring companies want to issue legal notice to your client that they owe the factoring company instead of your own company — the sort of notice that caused several of our clients to panic, and lost us at least one client. Their first question was, ‘Are you going into bankruptcy?’ Not the sort of question anyone wants to receive from a big new account, as you try to grow your business.

In the end, we found it far more profitable, and simpler, to require retainer deposits from our clients of 30 €“ 50% before we start work on a project. This allows you to sustain growth through cash flow, and check your new customer’s intention to pay, all at the same time. We’ve never had a client challenge or question the retainer requirement.

Diego Santangelo

In simple terms, factoring can be beneficial to a company who is having trouble collecting receivables. Basically, the factoring firm, for a fee, purchases your receivables at a discount — say perhaps less 10% depending on the firm; by doing so, the factoring firm takes on the responsibility to collect the receivables, relieving you from that duty. In turn, the money you receive for your receivables can go to pay your employee, etc. I hope this can shed some light on what factoring is.

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Originally appeared on PROFITguide.com
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