Historians trace the concept of selling receivables and debt obligations back nearly 4000 years to ancient Mesopotamia. Similar economic practices continued through the Roman empire and into the Middle Ages. The precursors to modern factoring appear in the American colonies, and today, some value the global factoring industry at over $3.6 trillion. Studies even show that, in some places, factoring companies are more financially stable than traditional banks.
Despite the strong history, however, a stigma surrounds factoring in the United States, which only makes up around 4% of the global factoring market. By comparison, Europe makes up over 50%. Given the enormous impact of the United States on the global economy, it’s strange to find such a disparity in this industry. Comparatively, the United States matches Europe in the worldwide banking industry, accounting for 24%, rivalling Europe’s 28%.
Why is there such a disparity between these two financial industries? We believe this is partially because of a lack of knowledge of factoring services, as well as many myths that plague the industry. Today, we hope to clear the water.
Myth 1: Factoring is only for troubled companies
Often, factoring companies have lower credit quality requirements when compared to traditional banks. This perhaps has given rise to the myth that factoring is only for troubled companies or companies with poor credit. However, correlation does not always equal causation. Factoring allows for lower credit quality, when compared to lending, because the source of repayment differs. While a bank depends on a borrower’s ability to repay a loan, a factoring company depends on their client’s customer to pay a receivable. Therefore, a company leveraging factoring can depend less on their own credit, and more on the credit of their customers. For example, suppose a three-month-old startup lands a contract to clean Walmart supercenters. A bank sees ‘startup’ and raises a yellow flag. A factor sees ‘Walmart’ and offers a deal.
This lower barrier to entry naturally attracts businesses with lower credit, but factoring can still benefit businesses with a spotless record. For example, sometimes, even if a business has a perfect record, a bank cannot supply a line of credit large enough to meet for the business’ needs. This often occurs when a business is growing quickly and so outpacing their line of credit. This is a good problem to have, since a growing business is often a thriving one, but can lead to significant cash flow issues. Factoring is sometimes the best tool for the job.
Myth 2: Factoring is Expensive
It’s true that factoring is often more expensive than a line of credit. However, factoring is often more flexible and generally offers larger facility sizes. $100K line of credit may be more cost effective, but it’s not that helpful if what you need is $500K. It all depends on your business’ needs. A line of credit that is too small may slow down growth. In the long run, passing up on opportunities because of limited cash flow could prove more costly than simply factoring from the start. Ultimately, it depends on your business’ needs and margins.
A good comparison when considering cost is credit cards. If your business carries the cost of accepting credit cards, you could likely save money by leveraging factoring.
Consider again the example of the startup servicing Walmart supercenters, but let’s determine some details.
| Revenue | 200,000.00 |
| Expenses | 165,000.00 |
| Net Income | 35,000.00 |
| Net Profit Margin | 17.5% |
Landing a large contract with such a large retailer could skyrocket the company’s revenue, lead to more opportunities, and potentially allow them to take advantage of economies of scale. It is common for factoring fees to fall between 1-5% per invoice (depending on a variety of factors). That amounts to a 1-5% hit to net income. That would drop the net profit margin, all other factors remaining the same, but accounting for the growth opportunities, and potential scaling efficiencies, that hit to the net profit margin could balance out.
Myth 3: Factoring is a loan
This myth is not only pervasive, but can lead to the myth addressed above; that factoring is costly. Factoring is an asset sale; lending is borrowing debt. The legal structure of the contract is different, the fee structure is different, and use cases are different. Factoring fees are charged either at the time of sale, or when your customer pays off the receivable (hopefully no longer than 120 days). By comparison, an interest rate accrues over the life of a loan based on the loan amount.
Misconstruing factoring (selling assets) as lending (borrowing debt), causes some well-meaning accountants and financiers to treat a factoring fee like an interest rate. This error leads some to calculate an APR (annual percentage rate) off the factoring fee, which, depending on the turnaround of AR, can lead to an annual rate of over 20%. But one glance at your business’ financial statements will tell you factoring isn’t costing you 20%, rather 1-5%.
Fallaciously confusing an interest rate with a factoring fee is like confusing apples and avocados–they are different things. A better comparison, as mentioned before, is a credit card processing fee, which is charged per transaction, rather than like an interest rate.
Myth 4: Factoring is complex
There is a certain complexity to any financial process, and factoring is no different. But the basic idea is very simple: you sell your asset (accounts receivable) to a factor at a discount and get access to your cash the day you invoice. The only additional step for you is submitting your invoices to a factor. Once the factor receives the invoices and verifies that your customers are creditworthy, they advance you 80 to 90% of the invoice value, keeping 10-20% back in reserve. The factor returns the reserve to you (minus the fee) once they receive payment.
Some factors will even offer non-recourse factoring. Recourse factoring means that a factor will return bad debt if your customer fails to pay according to the agreed upon terms. Non-recourse factoring means that the factor assumes the risk of nonpayment. This simplifies the process for you, since you can focus on growing your business. However, this form of factoring is often more expensive.
Myth 5: Factors only work with large companies
While it’s true that many large corporations, such as Coca Cola, have sold their receivables to increase cash flow, many factoring companies thrive by serving small to medium-sized businesses. In fact, sometimes factoring fits the small business profile better than traditional lending. As mentioned above, factoring relies on your customer’s creditworthiness, so it is a great fit for startups without established credit who are working with larger, more established customers. Further, a traditional lender looks in the rear-view mirror at where a company stood last year, in order to determine what size credit line to provide. For a startup, there is nothing in the rear-view mirror, which makes factoring one of the best options.
Myth 6: Factoring Companies Aren’t Trustworthy
This myth seems to be the natural consequence of believing the 5 myths previously mentioned. If factoring is a complex, expensive loan for troubled companies, then it can be used to confuse and oppress small business owners. These myths paint a negative picture and erode trust. Some even associate factoring with loan sharking. But as we have established, factoring and lending are distinct. Any financial instrument can be used poorly, and factoring is no exception. But when it is the right fit for a business’ situation, it can be a powerful tool to facilitate and sustain growth.
While it’s true that some factoring companies are untrustworthy and unethical, and do indeed propagate the myths addressed above, one could say the same of lenders, mechanics, or landscapers. The dishonest few should not become the stereotype for the entire industry, but should cause you to be vigilant in your search for a trustworthy financial partner. As a bank owned factoring company, we are federally regulated, and held to the same standards as our parent company. This helps us ensure high standards of security and accountability.
Wrapping it up
While almost every myth has a kernel of truth, that kernel does not make every myth entirely true all the time. Factoring works well for troubled companies, but also can help bring thriving companies to the next level. Some factors charge high fees, but others are cheaper than accepting credit cards. Some are trustworthy, and some aren’t. It’s important to do your own research, talk to the people, and figure out if what they’re offering is really what is best for your business.
