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The Mechanics of Factoring

Many small business owners ask, “How does factoring work exactly?” Here is the step by step process.

First the factoring company must do a credit check on the account debtor (the customer who will pay the invoice.) The critical issue is, you may be doing actual work for company A which is a very large corporation, but you are doing this work in the capacity as a sub-contractor – so the customer is actually company B, and they need to have good credit. Whoever is paying the invoice, that company needs to have the credit history necessary to finance your invoice.

The factoring company uses public information such as Public Filings and third party credit reports to determine creditworthiness. At this point in the transaction the factor is not contacting the customer directly.

The benefit for the factoring client is they get to check the credit of a potential customer before starting to do business with them. This allows our clients to know ahead of time whether they should be extending credit to a particular account debtor. The customer might also get a credit limit, so you might only finance invoices up to a dollar amount limit.

When a factoring client decides to finance their invoices for working capital to grow, they enter into a Purchase & Sale Agreement whereby they are selling the proceeds of an outstanding debt to a factoring company. Essentially the client (seller) is allowing the factor (buyer) to collect payments made towards an outstanding invoice.

Because this is an above board legal arrangement, all three parties must be aware of the agreement – this includes the customer. So the lender, whether it is a bank or a factor will send out a Notification message, either by snail mail or digitally, just to let the customer know that thanks to the partnership with a commercial finance company the factoring client has the financial backing to grow without the hindrance that comes from the lack of cash flow. The customer is instructed to make all further payments directly to the factoring company until the factor releases them from this obligation. Payments of invoices coming from customers going directly to the factor is the lynch pin of the entire process.

Once the customer has acknowledged the notification, the account debtor with good credit is ready to have outstanding invoices financed.

Gary Honig
Company: Creative Capital Associates Factoring Co. Nov 5, 2012