Factoring: a financing method used by business owners to raise capital by selling accounts receivable at a discount to a third-party funding source. The third-party funding source then collects the debt of the accounts receivable.
Factoring is a great strategy for many business owners. Factoring can provide life-saving liquidity to business owners for those in a cash crunch. It can provide cash very quickly. Funding can take place in as little as 24 hours for a business that has established a relationship with a factor. Otherwise it may take a week or so to get started. That’s light years faster than trying to get a loan or raise money on a crowdfunding platform, for example.
And because the factor is most concerned about the credit-worthiness of the debtor (the company that owes money on an invoice), it is not out of reach for a startup with no established track record (see three other financial resources for businesses without good credit). My newest book, Finance Your Own Business, provides many strategies for financing a business.
Case Study of When a Factor is Needed
Roger and Carol faced financial ruin. They were doing so well, and yet…
The two ran a company that provided unique locking bolts to advanced manufacturing firms. All their high tech customers loved their product. But they couldn’t get paid from their big company clients in a timely manner to keep the doors open.
They were owed $200,000 for bolts they had produced and shipped. But they owed $30,000 immediately to their suppliers, employees and landlord. Their accounts receivable (the money others owed them) was not coming in fast enough to cover their accounts payable (the money they owed others).
They called their Certified Public Accountant (CPA) for advice. For the first time ever they learned about factoring. A factor, explained the CPA, was a person or company who bought accounts receivable at a discount. This allowed Roger and Carol to get money in the door to pay their various expenses, and thus keep the doors open.
The CPA used one of their larger accounts receivable as an example. A Fortune 500 company, a large organization with billions of dollars in assets, owed Roger and Carol $50,000. While there was little question they would get paid — it was a billion dollar company — the wait was killing them. The CPA said a factor would buy the receivable for 70% to 85% of the amount owed. At 75% of the $50,000 receivable, the factor would pay Roger and Carol $37,500 right away. The factor would then collect the full $50,000 when the large company finally paid several months later. That would do the trick. The discounted receivable would provide the $30,000 they needed immediately to keep going.
How Factoring Works
There are three parties to a factoring transaction. The first is the one with the account receivable, or the seller. The second is the debtor, the customer of the seller. The third is the factor, the one who buys the receivable at a discount and receives the full amount of the invoice at a later date.
The sale of the receivable transfers ownership of it from the seller to the factor. In most cases, though not all, the factor notifies the debtor of the transfer, invoices the debtor and is paid directly by the debtor.
In non-recourse factoring, the factor takes the risk that the debtor doesn’t pay the bill. For this type of factoring, the factors prefer to participate in factoring transactions involving large, well-established companies. A Fortune 500 company is much less of a risk than a newly established business down the street with no credit history. As such, the factor doesn’t care so much about your credit history. They care about the debtor’s credit history — the business they (hopefully) are going to collect from.
When Factoring Doesn’t Work
Not all invoices can be factored. If a small company without a solid track record is behind on payments to you, for example, you’ll need to hire a collection firm, not a factoring firm. And to factor accounts receivable, the work or service must have been completed, or the product already sold. You can’t factor prospective sales. (However, a merchant cash advance may be an option in some situations. More on that in a moment.)
Invoice discounting is another form of factoring though it works slightly differently. Here, the invoice serves as collateral for a short-term loan and payment will be collected from the business that provided the goods or services. Again, it can be fast, but it can also be more expensive — much more expensive — than a short-term loan.
Choosing the Right Factoring Firm
Choosing the right factoring firm is important. Some specialize in certain types of businesses; medical, telecom, transportation or construction companies, for example. Others specialize in working with small businesses. You’ll want to check out the company’s history and background, and of course make sure they are a good fit for your business.
Personal Guarantees on Factored Transactions
Personal guarantees on factored transactions vary. Of course, for the business owner the ideal situation will be to factor an invoice with no personal guaranty required, and that is usually the case. But sometimes the contract will require the owner to sign a personal guaranty to protect the firm against fraud or misrepresentation, or it may require a full personal guaranty if the invoice that was factored cannot be collected.
Additional Advantages of Factoring
Factoring receivables can also be an asset protection strategy. Once the assets are factored, they are no longer assets of the company, which can reduce your company’s exposure, provided of course, that the proceeds have been spent or distributed.
A factor can alleviate you and your business of the headaches of tracking and trying to collect all of the company’s receivables.
Disadvantages of Factoring
You have to be very cautious. For example, Walmart is well known for not paying its vendors for several months. It is said that Walmart makes as much money on its ‘float’ as it does selling products. That is, by holding onto monies owed to others for as long as possible they can earn interest on that floating money reserve. How much interest could you earn by holding onto many billions of dollars for a few extra months? It should be noted that what Walmart does here is not illegal or improper. If you want that massive order from Walmart those are the terms, take it or leave it.
The problem arises when you try and factor the Walmart receivable. A factor will certainly take it on. They’re Walmart. The factor will surely be paid. But you may find there is no room for your company to make a profit. First off, Walmart’s huge order will likely leave you with a razor thin margin. They will grind you on the price knowing you want their mammoth order. But if you’re not careful, that margin may not be enough to cover the factor’s discounts. A number of companies have lost a large amount of money and/or gone out of business when they slashed their profits to get the business from large companies like Walmart, and then didn’t have enough room to factor the receivable. So talk to your factor about terms before you accept that gigantic order (both in terms of volume and challenge).
The cost of factoring is often not apparent since it is not expressed as an interest rate.
Factors do take on their own risks in these transactions. They can become involved in contractual disputes where the debtor refuses to pay the seller (and thus the factor). There are tax and legal risks associated with complying with all the laws and regulations in various countries. As well, some sellers are engaged in active fraud towards the factor. Fake invoicing, unassigned credit notes and misdirected payments are just some of the pitfalls facing a factor. They often earn their fees.
Factoring — Established in 1772 BC
Despite the risks, factoring has been around for a very long time. Of the 282 rules etched into the human sized stone that is Hammurabi’s Code, that incredible rock of law from 1772 BC, rules on factoring are included. From ancient Babylon to today, factoring is an established means of providing needed and timely liquidity to growing businesses.