Key Takeaways
- Factoring is a form of business financing that involves selling outstanding accounts receivable at a discount to a factor in exchange for same day cash
- Factoring primarily benefits companies experiencing rapid growth, managing slow-paying customers, or struggling to meet traditional lending requirements
- Factoring can give companies the liquidity and flexibility necessary to scale their businesses.
Introduction
Accounts receivable (A/R) factoring, invoice factoring, and factoring often refer to the same financial tool and fall under the larger category of accounts receivable financing. Freight factoring is a subset of factoring with nuances particular to the trucking industry. We will cover this subset of factoring in our guide to Freight Factoring.
In this guide, we aim to provide a comprehensive high-level view of factoring what it is, what it costs, and how companies can leverage it. Before diving in, it is important to understand certain factoring language.
- Factor: Refers to a company who offers the factoring services to businesses.
- Client: Refers to the businesses that use factoring
- Account Debtor: Refers to the customers of the client
Understanding these three players is crucial to effectively answering the three questions:
- What is factoring?
- What does factoring cost?
- How does factoring help?
What is Factoring?
Factoring is not a contemporary or unproven concept. Historians trace the precursors to factoring to ancient Mesopotamia, and find elementary forms of the modern practice in the American colonies. Today, although not as prevalent as traditional lending in the United States, factoring is still a respected form of commercial financing internationally.
To understand what accounts receivable factoring is, it’s important to know what it is not. True factoring is not a loan or a line of credit, it is an asset sale. This distinguishes between accounts receivable factoring and accounts receivable financing. Financing uses receivables as collateral for a loan/line of credit, whereas factoring involves the sale of receivables to a factor.
Authentic factoring is not debt, does not affect equity, and does not depend solely on the client’s credit. Rather, it depends primarily on the credit of the client’s customers.
Understanding Accounts Receivable
Accounts Receivable is an accounting term referring to services a business has performed (or products a business has delivered), for which the business has not yet received payment.
Consider a business that paints the stripes onto parking lots. Suppose they contract with Walmart and paint a supercenter parking lot, invoicing Walmart $10k with the agreed upon payment terms of Net 90. Until Walmart pays the invoice, the business considers it as accounts receivable on the asset side of the balance sheet.
Accounts Receivable + Factoring
Accounts receivable factoring involves selling of an asset (outstanding invoices or accounts receivable) at a discount to a factor so that a business can receive cash the day they invoice. Essentially, factoring speeds up the cash flow cycle by liquidating accounts receivable.
Advance Rates and Reserves
Often, factoring companies will initially advance 80-90% of the invoice’s value. The factor holds the remaining 10-20% as a reserve until the customer pays the invoice, at which point the factor will release the reserve to the client, minus the factoring fee. Sometimes the factor releases the reserve monthly or at the end of an agreed-upon period.
The Process
Provide the Service
As usual, the client provides a service or sells a product. Most factoring companies will not purchase invoices for incomplete work or undelivered product, because of the risks and complications down the line if the customer files complaints.
Invoice the Customer
Once the client completes the work or delivers the product, they invoice their customer as usual, and send a copy of the invoice to the factor. The client often sends invoices to the factor via email or uploads the batch through an online portal. Some factoring companies will generate invoices for the client, but that involves a deeper discussion.
The Factor Purchases the Receivables
The Factor receives and purchases the invoices, advancing cash to the client. Depending on the agreement, the factor will hold a percentage of the invoices in reserve until the customer pays.
Ongoing, the factor verifies the validity of invoice documentation. When necessary, the factor contacts the account debtor to ensure that the client has completed the work and delivered the invoice.
Customer Remits Payment
The account debtor remits payment to the factor, and the factor charges their fee. Depending on the type of factoring agreement, the factor may release the reserve at this time, or at the end of a designated period.
Common Forms of Factoring
Is factoring equivalent to outsourcing collections? Not necessarily. Two primary forms of factoring exist in the United States, commonly referred to as recourse and non-recourse factoring.
Recourse vs Non-Recourse Factoring
Is factoring equivalent to outsourcing collections? Not necessarily. Two primary forms of factoring exist in the United States, commonly referred to as recourse and non-recourse factoring.
Recourse
In recourse factoring, the factor reserves the right to return an invoice to the client should a customer fail to pay within the agreed upon terms. Just as a consumer may return a defective product for a refund, so a factor may return a faulty receivable for a refund in a recourse factoring agreement. Depending on the agreement, the factor may refund unpaid receivables from the client’s reserve, or from the next incoming sales batch. Generally, only when the reserve is insufficient to cover the chargeback will the factor ask their client to pay the difference. Often, business owners find recourse factoring appealing because of the lower fees, since they, as the client, are responsible for collecting on bad debt.
Non-Recourse
If recourse factoring is comparable to a consumer return and refund, non-recourse factoring is the opposite – all sales are final. Once the factor purchases the invoice, they take on the risk of nonpayment. There are no take backs, no returns, and no refunds. The client is therefore free to focus on growing their business rather than acting as a debt collector. The factor purchases the invoices and handles collections. Often, this type of factoring charges higher fees, since the factor takes on more risk by forfeiting the right to return bad debt and is responsible if the client’s customer doesn’t pay.
Spot Factoring
While most factoring relationships are ongoing and require the client to sell all of their receivables to the factor, a spot factoring relationship is different. When using spot factoring, a business owner may pick and choose which invoices to sell to a factor whenever the need arises. This allows for more flexibility for the client. However, spot factoring can be more expensive and have stricter invoice requirements.
What does Factoring Cost?
Factoring fees often range between 1-6% per invoice. While this is often more expensive than traditional bank lending, it is important to distinguish that comparing a factoring fee and an interest rate is like comparing apples and avocados. The two are structurally and functionally different. A more accurate comparison would be between a factoring fee and a credit card processing fee. In order to accept credit cards and speed up customer payments, a company must consider the credit card fees and the per-transaction rate charged by the credit card processor. This cost of accepting credit cards concept applies to factoring and if a business finds a good factor, the fees could be more cost effective than accepting credit cards.
That being said, 1-6% per invoice is a wide range, especially when dealing with large dollar amounts. Generally, a factor determines the client’s rate based on the following considerations:
Items Impacting your Factoring Rate
Your Account Debtors
The greatest impact on your factoring rate is your customers or account debtors. Once you sell receivables to a factor, it is up to your customers to pay back the receivable to the factor. If a customer has a poor credit history, or poor payment history, the factor will be more reluctant to work with them. A factor doesn’t want bad debt. The poorer a customer’s credit, the more a factor will charge to mitigate the risk.
Your Volume
As with any industry, there are economies of scale. The greater the sales volume, the more receivables, the better the price you can negotiate. Considering two companies equal in every respect except size, a company operating with $10 million in sales will probably find a more competitive rate than a company doing $200 thousand.
Your Payment Terms
The payment terms you negotiate with your customers will also affect your factoring rate. If your payment terms are Net 120, as opposed to Net 60 or Net 30, then a factor will charge more. Longer payment terms increase the risk of nonpayment, and constrain the factor’s cash flow. Both considerations weigh into the factoring rate.
Your Industry
Some industries are riskier than others. Construction, for example, involves intricate contracts with stipulations and requirements that, should a project not go as planned, can make it a nearly impossible for a factor to receive payment. Some industries are complex and not all invoices are created equal. Factoring for staffing companies can sometimes require the client to submit timecards along with invoices. Overall, industry matters, and affects pricing.
Recourse vs Non-Recourse
As previously mentioned, in recourse factoring, the factor reserves the right to return bad debt should your customers default on payment. The ability to return bad debt means that the factor takes on less risk and thus can afford to offer more competitive rates. Non-recourse factoring means that all sales are final; the factor cannot often return bad debt. This can make things simpler for you, the client, since you won’t need to worry about collections, but it increases the risk for the factor, and so increases the factoring fee.
Factoring Fee Structures
Of course, the factoring company must make money somewhere, and the fee is charged in different ways, depending on how a factoring agreement is structured. The two primary fee structures are:
Fee on Sale
With this structure, the factor charges the free when the client sells the invoice (Fee on Sale). The benefit to Fee on Sale is the fixed fee structure. It is easy to calculate the overall costs of doing business with a factor.
Fee on Payment
With this structure, the factor charges the fee when the customer pays the invoice. Often the factor deducts the fee from the reserve, so that when the reserve is released at the end of the period, the fee is subtracted. For example, an agreement structured in this way with a 90% advance rate, a 10% reserve, and a 3% fixed fee would have a 7% reserve release. This fee structure is more flexible and variable. If customers pay early, the fee is lower, but if they pay late, the fees continue to accrue.
How does Factoring Help?
To understand the benefits of factoring, one must understand the benefits of cash flow, since, at its core, factoring speeds up the cash flow cycle. This allows companies to operate with more flexibility and liquidity. Although not a silver bullet to generate more revenue, business owners can leverage this tool to unlock their potential.
There are many other solutions to the problem of poor cash flow, such as equity investors or traditional bank loans. While each excels in serving a subset of the marketplace, neither fits every situation perfectly. Bank loans often require hard assets as collateral, and not every business has the luxury of owning large amounts of real estate, especially startups and service-based businesses. Alternatively, equity investors expect ownership, which is not always in the cards. Not every business fits these arrangements, and sometimes settling is akin to shoving a square peg into a round hole. Lending and equity investing work well for what they’re designed for, and a line of credit will often be less costly than factoring, but the question really rests upon the client’s unique situation and needs.
Who does Factoring Help?
Factoring, like lending and equity investors, is most beneficial in specific use cases. It is not a one size fits all solution that can transform any business. Some industries and business structures are better served by traditional forms of financing. Industries that commonly benefit from factoring include supply chain logistics companies, such as trucking, wholesaling and distribution. Manufacturing, business services, and temporary staffing companies are also common factoring clients. However, industry categories do not perfectly reflect the unique needs and circumstances of individual clients. Therefore, it can be more helpful to consider the unifying business profiles/circumstances where factoring best fits, such as:
- Slow-paying customers
- Rapid growth
- New opportunities
- Startups
- Does not fit traditional lending requirements
Slow-Paying Customers
Servicing customers with slow payment terms can bottleneck cash flow, which can make it nearly impossible to continue growing, or even operating. If payroll deadlines roll around faster than customers pay invoices, or supplies need to be purchased before taking on a new job, things can go south fast. Some businesses can afford to wait 30, 60, 90 or even 120 days, but the cost of carrying receivables is never zero. Missed opportunities, and slow cash flow will inevitably inhibit the bottom line. Factoring is tailormade for these situations. Instead of waiting, a business can convert receivables to cash and pursue new opportunities.
High Growth
For companies experiencing rapid growth, cash flow is crucial. Rapid growth, without cash flow, is like driving a car focusing on the speedometer while running out of gas. Eventually, all that growth will come to a screeching halt, and the company will collapse under its own weight. A line of credit could help, but banks examine a company’s history to determine the line limit. For businesses growing at 15-20% per year, a credit line based on last year’s numbers doesn’t reflect this year’s needs. Although a line of credit may help, the line may not be large enough to sustain the desired growth. If you max out your line of credit you no longer have cash flexibility, all business assets are usually pledged and you now have a fixed monthly payment to reduce the line balance. A business will find themselves in the same situation, with an empty gas tank. Alternatively, a factor examines current receivables and payment history to determine facility limits, and may be able to increase that limit as needed. Essentially, lending looks in the rear-view mirror, factoring looks ahead through the windshield. This allows factors to be nimble in providing the working capital necessary to sustain high growth.
New Opportunities
Some clients stand on the verge of tremendous opportunity that could double, or even triple, the size of their business. Perhaps they landed a government contract, or a large project for a slow paying Fortune 500 company. However, they don’t have the working capital to take on that large customer. This mirrors the high growth profile and presents similar problems. A traditional bank loan could meet some of the need, but banks often require real estate collateral, or will examine previous years’ performance. Past performance, however, may not account for growth from large new contracts. Factoring, in this case, is best suited to meet the need.
Startups
Startups are in a precarious position for securing working capital. They may have passion and an idea, but for a bank, passion and ideas aren’t collateral. Additionally, two years of tax returns are often required for securing a line of credit, and even then, most banks, especially community banks, still require hard assets, such as real estate or equipment. It’s not that the bank doesn’t want to help, however, just that their lending requirements are sometimes are too strict for startups.
Equity investors are an option, but once again, without history, justifying a substantial valuation can be difficult. The business may not have enough equity, or the investors may ask for more than the owner will relinquish.
Depending on the startup’s structure and customer base, factoring can be an effective solution. The quality of a startup’s receivables is more important to a factor than the startup’s brief history.
Does not fit Traditional Lending Requirements
Lastly, some companies don’t qualify for the loan they need. We addressed a startup situation where hard assets are scarce. But what if the situation is more bleak? Suppose the business experienced a difficult financial situation two years ago, or an economic tectonic shift like Covid left them scrambling. Traditional financing may not be an option, but factoring might be.
Factoring looks at your customer’s credit first, and your credit second. Even if you had a rocky financial history, or just a poor year, you may still qualify for factoring. Factoring is the sale of an asset. If the asset is good, a company’s financial woes are less of a concern.
Selecting a Factor
Choosing a new financial partner is significant, and a business should properly weigh all factors (no pun intended). When looking for a lender, a credit card processor, or a factor, it is important to research and verify not only the institution’s credibility but also whether their product is truly the best fit for your business’ situation. Unfortunately, some financial service providers lock companies into contractual agreements for products that aren’t a fit.
Below are several considerations when selecting a factoring partner.
Fee Structure
Understanding the fee structure is critical when considering a factoring agreement. Some factors advertise high advance rates and low factoring fees, but will nickel and dime their clients to death with additional, sometimes hidden, charges, which may include setup fees, service fees, minimum volume fees, ACH fees, late fees, and lockbox fees, just to name a few. Worse, some factors legally lock businesses into long-term contracts with exorbitant exit fees in order to keep their clients onboard.
Considering other aspects, such as whether the agreement specifies fee-on-sale or fee-on-payment, is also important. If your customers pay quickly, fee-on-payment may be a better option, since the fee will have less time to accrue. Alternatively, fee-on-sale may be a better fit if your customers consistently pay in 120 days.
Finding an honest and upfront factor will make or break a factoring experience. If a factor is so afraid of losing your business that they will lock you into a contract, it may be worth looking elsewhere. As with anything, if it seems too good to be true, it probably is.
Accountability
Ensuring that a factor is reputable, respected, and abides by all applicable laws and regulations is essential. Legitimate reviews can be a helpful indicator, as well as the factor’s admission into groups such as the International Factoring Association (IFA), which is predicated on the factor’s ongoing ethical business practices.
A factor that is bank owned can also be a positive reputational indicator. Factoring is an ancient method of financing, but modern factoring is a relative newcomer in the United States, and thus the regulatory framework is less developed. Conversely, state and federal governments strictly regulate the banking industry, and require adherence to stringent guidelines in areas of accountability, data security, and operational consistency. As many banks have proven, governmental accountability does not preclude the need for personal responsibility. Rather, the intention is to encourage ethical business practice. Bank-owned factors must adhere to these standards and face scrutiny from internal auditors, external accounting firms, and state examiners.
Customer Service
Very little needs to be said about the importance of customer service. It can make or break any experience and is especially important in financial services industries. Trust, empathy, and professionalism are crucial. Unfortunately, the quality of customer service can be difficult to gauge prior to entering a factoring relationship. Reputable reviews and references are invaluable. Examining the sales process and the sales representative’s attitude can also be helpful indicators. Of course, a factor must charge fees and protect their assets, but any honest savvy business owner knows that treating the customer right is the best way to build a sustainable business. The same is true for factoring.
Recourse vs non-recourse factoring
We covered this topic earlier, but it is worth noting as a consideration when selecting a factor. Some factors offer both, while some specialize in only one variety of factoring. Which form a business selects affects not only the costs of factoring but also the time and costs involved in collections and accounting for chargebacks.
Conclusion
There’s always more to be said about factoring (as with any industry). Hopefully, this guide has helped to shed light on what factoring is, what it costs, and how it helps, as well as given you basic insight into the process and what to look for when choosing a factor. If you’re interested in learning more about how factoring can help you specifically, we welcome you to set up a call with us. We’d be happy to answer any of your questions!
