Learn everything you need to know before you get started with factoring!
While more people seem to be learning about this form of financing on a daily basis, it’s still largely misunderstood. Invoice factoring is the sale of a company’s receivables to a finance organization in exchange for immediate payment. This type of funding is not a loan and therefore is not recorded as debt on the balance sheet.
For example, when Company A provides it’s good or services to a business, but there are terms associated with the payment (typically 30 days or longer), Company A may find it difficult to continue operations until the payment is collected. Now, imagine this on a larger scale where Company A works with several businesses, all of which take 30 days or longer to pay. In order to maintain an uninterrupted workflow, Company A has the option of selling its receivables to an invoice factoring company. This factor can provide an up-front payment in exchange for Company A’s receivables, thereby eliminating the need for them to wait the weeks or even months to be paid by their customers.
Although the basics of most transactions are the same, there can be slight variations to the process depending on the funding company used and the specific industry in which Company A operates. Before getting into the transactional details, it is important to understand a few of the common terms associated with factoring:
Advance Rate / Advance – When the factor pays Company A up-front for the invoice, the initial amount that is paid is referred to as the advance and is based upon the gross value of the receivable. Depending on the industry in which Company A operates, the advance rate will typically vary anywhere from 70 – 95%, or even more.
Reserve Account / Reserves – After depositing the advance in Company A’s bank account, the invoice factoring company will hold the remaining funds in a reserve account. These reserves are held until the invoice is paid in full. In the event the invoice is short-paid, these reserves will be used to cover the difference. Once the full invoice value is collected, these reserves are refunded directly to Company A.
Factoring Fee – This is the cost of the transaction. Company A and the factor will agree to a fee structure at the beginning of their relationship. As soon as a factored invoice is collected, the small fee is then deducted and the remaining reserves are refunded to Company A.
Following is a general outline of the factoring process:
Some of the industries where accounts receivable financing is the most prevalent include temp staffing, manufacturing, transportation/trucking, construction, medical/healthcare, government contracting, and other service-related businesses. However, as long as Company A provides its services to another business (not a consumer), and payment is based on terms, Company A may benefit from factoring. While typical payment terms on factored receivables range from 30 – 90 days, there are also some companies who find difficulty waiting even 10 or 15 days for payment. On the other hand, some businesses experience payment terms greater than 90 days, and these organizations may be great candidates for accounts receivable financing as well.
Invoice factoring is a great working capital resource for start-ups and existing small businesses that encounter difficulty obtaining traditional bank financing, and for companies that experience seasonal fluctuations or rapid growth. Whether an organization has limited time in business, past bankruptcies, previous or existing tax liens, or other roadblocks that hinder access to a line of credit, invoice factoring is often the perfect solution. The invoice factoring company does not focus on Company A’s credit when entering into the relationship. Since Company A’s customer will be the entity paying, the factor is only concerned with that customer’s credit. For example, if Company A has only been operating for 6 months and has not established much credit history, but they provide services to Wal-Mart, the funding source will welcome that business with open arms due to the fact that Wal-Mart is credit worthy.
Businesses that factor will find all sorts of uses for the working capital they generate. However, one of the most common uses is to cover payroll. Employees expect to be paid on a regular basis and the last thing any employer wants to do is come up short on payday due to the fact that all of their capital is tied up in outstanding invoices. Another common use is for the purchase of materials and supplies. If an organization is not reimbursed for their materials until their customer pays the invoice, this often restricts their ability to accept additional jobs and causes unnecessary growing pains. While these are just a few common examples, the fact is that the proceeds realized from selling receivables can generally be used for any type of business purpose or overhead expense imaginable.
The obvious, first answer to this question is Google. Given the ease of access to information, it is always advisable to perform a basic internet search for accounts receivable factoring companies serving your specific industry. However, once some of these candidates are highlighted, be sure to read through their websites to learn as much as possible. Many invoice factoring companies will maintain a blog that can provide some insights into how they function. Eventually, a telephone conversation is inevitable as well as highly recommended. Asking a factoring company representative some basic questions (see section below) will help to provide the most accurate information available in regards to their operations.
Some additional referral sources that may prove beneficial are accountants, attorneys, or business bankers. These individuals will oftentimes have developed relationships with quality funding sources simply in their regular course of business networking. It can’t hurt to check with these professionals in the event that they are able to provide a truly honest referral.
A third approach to finding the “right” small business factoring provider is to contact a factoring broker. These intermediaries can often be found with a quick Google search. A knowledgeable broker will have relationships with dozens of reputable factoring firms specializing in a variety of industries. Good brokers help connect their clients with the best funding solution available for each specific client, but only after learning about their client’s business and cash flow needs. Best of all, brokers do not charge the factoring prospects for the services that they provide.
Due to the broad spectrum of accounts receivable financing companies in operation today, this is perhaps one of the most important items to consider. It is always best to speak with multiple factors and ask a variety of questions in order to find the best relationship to meet your needs the first time around. Following are just some of the items to discuss with potential funding partners:
Do they specialize in your particular sector?
If you operate a trucking fleet, you will be better-served by a freight factoring company as opposed to one who specializes in the construction industry.
Do they require long-term contracts?
Even though month to month contracts have become more commonplace, 12 month arrangements are still the norm in some industries. While longer contracts are not inherently negative (acceptance of longer terms can be used to negotiate other, more favorable concessions), one must take the appropriate measures to become entirely comfortable with the factor prior to entering into a long-term relationship.
What are the advance rate and factoring fees?
Unfortunately, it’s impossible to discuss specifics here simply due to the fact that there are almost an infinite number of advance rate and factoring fee structures. However, speaking with more than one receivables factoring company allows you to compare different offers and determine what works best for your unique needs.
Are there any other fees?
Different industries can require extra charges in addition to the factoring fee (i.e. start up fees, processing fees, bank deposit fees, etc). Therefore, it’s always important to ask each prospective funding source if they charge any additional fees and to obtain the details of these charges in writing prior to moving forward.
How quickly can the factoring company provide funding?
Same-day funding has become an important selling point for many factors, but it’s not necessarily possible within all industries. As such, it’s always important to know just how long it takes the companies you’re considering to fund invoices.
Many small and medium-sized businesses in the United States are still experiencing cash flow difficulty, despite the supposedly relaxed credit requirements among banks. As a result, the accounts receivable factoring industry has seen tremendous growth. This increase in the number of working capital lenders has led to a general reduction in factoring fees along with an increase in customer service excellence, not to mention the offering of additional services such as short term loans for factoring clients. All of these changes have led to the growth of thousands of companies which would have otherwise been forced to shut their doors. While it may seem a daunting task to begin the search for a factoring company given all the options available today, your dedication to performing adequate due diligence on each candidate will be well worth it in the end.