What do you do when you find yourself in need of capital, but can't get (or don't want) a traditional bank loan? For business owners in need of fast cash, using a factoring service may be the answer.
Factoring is an alternative method of finance that allows business owners to sell their invoices, or accounts receivable, to a third party commonly known as a factor. Invoices are sold for a certain percentage of their total value. This means you'll receive most of the payment for goods or services you provide to your customer base almost immediately. The factor then collects your customers' payments and forwards the rest of the cash to you, less the company's service fee.
This approach to financing is attractive, as it allows you to receive cash almost immediately, regardless of the size of your business or its track record. In addition, you may be able to factor more than you can borrow through a commercial lender as long as you have an adequate stream of valid invoices for reliable accounts. But in some circumstances factoring isn't always a viable option.
After handing over copies of your accounts receivable, the factoring service pays you between 70 and 90 percent of the total invoice value within two to five days of receipt. If the factor you select accepts electronic invoices, funding may be available in as little as 24 hours.
But before accepting your invoices, the factor will conduct due diligence to determine the creditworthiness of your customers and whether or not they will be capable of paying their invoices on time. This is an essential step, as the factor typically does not function as a collection agency. To qualify for factoring, accounts have to be in good standing.
After accepting your customers, the factor reviews all outstanding invoices and inspects them for accuracy and completeness. If all signatures are in place and the invoices have been properly issued, the factor requests payment from your customers by sending them a notice of assignment. This informs the customer of the service you're using and instructs them to send all future payments directly to the factor.
Once payment has been made, the factoring service transfers the remaining balance owed on that particular invoice to you. The service also deducts its fee (also known as a discount rate), which is usually between 2 and 6 percent of the invoice total. It's worth noting that the individual factor and particular structure of the deal you sign up for will affect the discount rate. For example, some factors may offer up to 90 percent of your accounts receivable upfront, but charge a 6 percent discount rate. Others may provide 80 percent upfront and assess a 3 to 4 percent fee.
To help you track your revenue and expenses, many factors now provide online access to your account. This enables you to keep tabs on the process in real time, from notice of assignment to final payment.
The most notable benefit of using a factoring service is that it gives you almost immediate access to the cash you need - making it easy to fund a product launch or growth initiative. However, there are many other positives that make factoring a great funding option.
There are two potential downsides to using a factoring service. The first is that it can be more expensive when compared with other financing options like traditional bank lending. The service fee may seem small, but it can add up, depending on how much you have in outstanding invoices and how long it takes to collect on them.
That said, the steeper price may be worth it. Factoring can be a perfect working-capital solution as long as the opportunity cost outweighs the factoring cost.
The second concern is that factoring may not work for companies that have on-going relationships with their customers. Some clients might not take kindly to having their invoices handed off to a third party which may not treat them the same way you would if you were trying to build a strong bond with them. Factoring may be better suited to businesses that don't often have repeat customers or for whom building strong customer relationships is not a priority.
To help determine if it's right for you, look at the opportunities you may be missing by not factoring. In particular, keep in mind the launch initiatives or growth opportunities mentioned above. It's important to view factoring as a financing strategy conducted over a period of time. Within this framework, realize that it can help you expand or recover while achieving specific long-term goals.
Generally speaking, factoring is only beneficial to those with a reliable client base, which means businesses that have a net 30 or net 60 payment structure. Factoring is not a solution for companies in dire financial situations. If your company has substantially more accounts payable than accounts receivable, factoring is probably not a good idea.
Factoring services are commonly confused with collection agencies. But there is a substantial difference between the two. A factoring company advances you funds based on outstanding invoices owed to you by creditworthy customers. A collection agency assumes the debt of a past-due invoice and attempts to collect it for you through letters, phone calls and legal processes when applicable.
This general purpose is one of the primary differences between the two services. Factoring supplements periods of poor cash flow you may be experiencing by providing funds for a large percentage of your qualifying receivables. This saves you from having to wait the 30, 60 or 90 days some businesses require to submit payment. Contrast this with debt collectors who are attempting to recover old debt - invoices that have gone beyond the accepted payment window. With this setup, you receive nothing upfront and only receive a percentage of the debt after it has been successfully recovered.
Far more similar to factoring than debt collection, bank lending is a form of financing based on your creditworthiness as the business owner. Also known as asset-based lending, the bank variety provides funds secured against your business assets, including property and industrial equipment.
In many cases, the guarantee can be issued against the very item you're seeking funds for - equipment, for example. In these instances, the lender will determine the total funds you qualify for by assigning a borrowing base - a percentage of the market value for the assets you hope to acquire or currently hold. This figure is usually 50 percent of the total value or less. The same lender may also offer a line of credit on your accounts receivable between 70 to 90 percent of their full value.
It's worth noting that a line of credit is continuously in flux, with a borrowing base that may shift from month to month. Affected by new invoices submitted for payment as well as payments received on older invoices, this system is often available only to businesses with an established track record and that hold valuable assets.
In contrast, factoring services shift the focus away from the history of your business and place it on the value of your accounts receivable. As covered in detail above, this process provides immediate payment on invoices that could extend to net 60 and beyond.
One notable difference between the two financing methods is that asset-based loans typically start around $700,000 and are commonly in the $2 million to $25 million range. By comparison, there is no minimum for a factoring service, making it ideal for small businesses and startups.
The final distinction between the two may be the biggest: cost. Asset-based loans are more costly over the long term because they operate on an annual percentage rate (APR) between 5.6 and 8 percent (usually figured as prime plus 2 to 5 percent). This is in contrast to a factor that takes 2 to 6 percent of the value of the entire invoice or 0.6 to 1.2 percent for every 10 days that invoice remains unpaid.
When comparing factoring services, there are two main classifications and an assortment of various types. The two main categories are:
Within these two main factoring categories, there exist a number of different types designed to address specific business situations and needs. The following include the more common of these types:
Falling within the recourse classification, this type of factoring leverages your accounts receivables as collateral to provide immediate funding. The purpose of this type of factoring is to free up capital that is trapped in receivables while shifting your business focus away from collections and onto growth, product development or another area of importance.
Unlike nonrecourse factoring, the factor may be willing to accept older invoices. But the older the invoice, the higher the discounted rate you can expect to pay.
Popular for its ability to eliminate bad debt, invoice factoring allows your company to turn over accounts receivable to a factoring service that will assume all of the risks associated with uncollected invoices. Somewhat similar to nonrecourse factoring, it differs in one critical way. Invoice factoring acts in a way that's similar to a line of credit: The factor (known as a financing factor in this case) offers immediate funding, which is secured by the goods to be manufactured using the capital provided.
This is another hybrid of factoring and a line of credit, and there are actually two different varieties. In the first type, the lender provides a short-term loan using your accounts receivables as collateral. Similar to recourse factoring, a discounted rate applies and the total value is usually in the range of 80 to 90 percent. This is the total amount of funds your business would qualify for. Unlike a standard factoring process, the invoices are not purchased outright, but rather only used for the security of the loan.
The second type is similar to nonrecourse factoring in that the lender will actually purchase the invoices and will be responsible for collecting them. Given the extra liability, the total value of your accounts receivables for services of this type is usually between 70 and 85 percent.
Combining nonrecourse factoring with debt-collection services, a debt-factoring service assumes responsibility for uncollected invoices, immediately providing partial funding on the invoices while eliminating bad debt. This type of factoring can be more costly than others, as the factor will first explore your business operations to assess the difficulties involved in collecting on your receivables. This process will be used to calculate the discounted rate you pay, with a total value that's commonly between 70 and 85 percent.
Sometimes known as service factoring, this type turns over more control of your accounts receivables to the factor. Within this setup, the factor manages your invoices, customer credit and payment schedule, and provides funding (less the discount rate) on all invoices as they come due, whether or not the customer has actually remitted payment.
Another form of nonrecourse factoring, this type advances the entire value of your invoices, less the discount rate, upfront. Similar to nonrecourse factoring, the factor assumes all liability for collecting debts. But unlike other forms of factoring, the payments are not split into two disbursements: one paid immediately and the other after the invoice has been paid. With full advance factoring, you get everything at once.
This type of service is extremely rare - few factors offer it because few customers are able to qualify for it. Qualifications typically include an exemplary credit score and a long track record of payments made in full.
Highly similar to recourse factoring, bulk factoring provides financing based on the total value of accounts receivable, a figure that's commonly around 80 percent. Also known as in-house factoring, it's a process that allows you to take advantage of the financing opportunities of a factoring service, yet maintain control of all operations related to your accounts receivables.
Used mainly as an alternative to a bank loan, bulk factoring requires you to do your own collecting and therefore saves little in the way of time and legwork.
Up to this point, we've been looking at a generalized percentage range when referring to a factor's discount rate. To recap, it's typically between 3 to 6 percent but may be presented as anywhere from 1 to 5 percent. It's important to understand that there is a lot more involved with the discount rate than just the creditworthiness of your customers.
To determine the rate a factor will offer you, the service will consider a number of different business indicators. These include:
When you enter into a factoring agreement, most providers require you to sign a contract that holds your accounts receivable as security and works in lieu of physical collateral. Within this contract, there are a number of things to watch out for and even a few ways to use the arrangement in your favor.
Factoring companies often specialize in businesses operating within a certain niche, size or annual revenue. While you may qualify for a range of factoring services, not all will provide the same level of service and cost effectiveness.
An easy way to compare the strengths and weakness of a factoring service is to search for reviews online or ask to see references provided by existing customers. This will give you a general overview of the level of service provided.
To determine whether the factor you're considering is a good fit for your business, it's important to speak with a representative from that service. This provides an opportunity for you to ask any additional questions. More important, it provides a window into the level of service the factor provides, including everything from responsiveness to professionalism.
These are critical concerns, as most factoring services will be in direct contact with your customers and are often viewed as an extension of your business. Ask to see sample copies of the different types of communication routinely sent to customers, including emails and letters. Some may even let you listen in on a phone call. The purpose of this is to add weight to those services that mirror your core business values.
This is another area that can be a surprise if you're not expecting it. But it's also an area that may be negotiable. When comparing factors, ask about any setup costs involved with establishing an account. A common example includes a one-time fee of $500 for basic application processing to a minimum of $2,000 to process your application and conduct all due diligence, including inquiries related to tax liens, credit report and client invoice validation.
By Sylvia Rosen, Senior Editor businessnewsdaily.com
Brittney Helmrich and Sara Angeles also contributed to this story.