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Why Factoring?

Probably the most notable aspect of this financial tool that I have encountered over the last 18 years is how many people have never heard of invoice factoring and have no idea what it is. If I say, 'small business financing,' it helps. But usually I hear, "gee if I had known about this in our formative years I really could have used your services."

In its most basic form, factoring is very easy to understand. A company is growing and needs extra capital to make sure that bills are being paid on time. This includes operating bills or payroll and taxes. Factoring accounts receivable is where the finance company uses loans, in the form of invoices, to provide the outside capital companies need to keep growing.

Make sure you understand the difference between debt or asset based funding vs. equity investment whereby you are selling parts of your business in exchange for capital. One of the benefits of factoring is the off balance sheet nature of the transaction whereby there is no long term liability affecting the value of the business.

When a company provides their services or delivers an ordered product and offers payment terms (like net 30 days) they are becoming the lender. They did the work, and the customer owes them money for payment of that work. Unfortunately most businesses don't realize this distinction of becoming the banker and make mistakes like not formalizing the credit properly - either from a paperwork standpoint or not using a dependable due diligence process. Plenty of customers will buy on credit when their credit is no good. What steps are being taken to minimize the risk of offering terms to a buyer who couldn't qualify for a loan?

It's important to understand that factoring is much more than a finance company furnishing working capital to a client. Factoring companies provide a suite of services to help insure the ongoing viability of their clients businesses. It all starts with having invoices for completed work.

First the factor will determine the creditworthiness of the customer. In other words, is the company offering payment terms to a customer who has enough good credit history? So by utilizing factoring it helps businesses by making sure they only extend credit where it makes sense. This scenario has played out countless times - a customer doesn't pay a very large invoice essentially taking a huge chunk of annual profit from the selling company.

Historically the major benefit to using invoice factoring is a company with weaker financials can sell to a customer with a strong financial condition and leverage that transaction to their advantage.

Next, the factor has to verify the invoice as due and owing. The client must have completed the work fully and have it accepted by the customer. No half jobs done or partial shipments. The benefit here to the factoring client is independent verification that the customer understands and accepts the obligation to pay what is owed in the agreed amount of time. This formality protects the client from future discrepancies or non-payment.

And lastly, the factoring company will be active in retrieving a timely payment from the customer. It seems counter intuitive but the factor wants payments to made within the agreed upon time period because statistically late payers become problems and increase the risk of default.

Normally the relationship with the factor extends over a period of time which allows this sort of oversight to be incorporated seamlessly into the everyday operations of their clients business. This riding of the growth trajectory sets up a perfect transition to conventional lending with a bank once a critical mass of annual revenue has been reached.

A few good questions to ask when looking into factoring as a funding solution:

  1. What is your industry? Some factors specialize within certain types of vertical markets.
  2. What terms and conditions will be required? Contract minimums, time periods etc.
  3. How does the funding process work?
  4. What does it take to qualify for factoring?

Gary Honig
Company: Creative Capital Associates Factoring Co. Oct. 21st, 2015