What is factoring?

Factoring is an innovative method of business financing that allows clients to get an accelerated payment on their slow paying invoices. Traditionally, when a company offers its services to another business, they need to wait between thirty to sixty days to get paid. Although companies that have a large cash cushion in the bank can absorb the cost of waiting to be paid, small and medium sized businesses cannot. This can jeopardize a companys ability to meet existing payment obligations, or worse, prevent it from capitalizing on new opportunities.

This is where factoring can be a very helpful tool. A factor can provide a company with an advance payment on its accounts receivable. The factor then waits to be paid by the clients customers, while the client gets use of the funds immediately. The transaction is structured as the sale of a financial right, rather than as a loan. Because of this, the factor focuses more on the strength of the customer paying the receivable rather than on the financial strength of the client. This makes factoring the ideal financial tool for new, small and emerging businesses.

Keys features when looking for a factor

Selecting the right factor for your company can be a very complex task. Given the importance of the factoring relationship to your companys ability to succeed and grow, it is critical that you do the proper due diligence when selecting a factoring partner. Here is a list of some of the criteria that are important when selecting a factoring financing company:

Factors Comfort Zone:

Almost every factor will advertise that they can work with an account that requires as little as $10,000 per month and as high as a few million dollars per month. Although that may be true in principle, the reality is that managing a small volume account is very different from managing a multi-million dollar account. Most factors tend to develop a comfort zone or preferred specialty when it comes to client size. When selecting a factor, always ask about the size of their typical client. Ideally, the size of your business should not be significantly below or above that figure.

Monthly Minimums:

Most factors will only take clients that commit to transact a minimum financing volume every month. The advantage of committing to monthly minimums is that the factor will offer your company better terms. The main disadvantage is that if your factored volume drops, your company could be liable for making up the difference in fees. When selecting a factor, be sure to select one whose minimums are well below your expected minimums, or better yet, try and find a factor with no minimums.

Recourse vs. Non Recourse:

Recourse is a term that defines the ability of a factor to re-sell the invoices back to a client if an invoice does not get paid within a given period of time. Most factors prefer to operate in recourse mode. However, there are a number of factors who offer non-recourse agreements. Under a non-recourse agreement, the factor will absorb the losses on an invoice if the account debtor becomes financially insolvent. In effect, non-recourse factors offer some protection against bad debt. Although you are generally better with a non-recourse factor, most recourse agreements work well enough.

Contract Duration:

Typically, factoring contracts require a minimum term of one year or more. Whereas longer-term contracts enable a factor to offer you better pricing, they can also lock your company into a factoring arrangement that outlives its usefulness. Your best bet is to try and find a factor that will allow you to easily terminate a contract (giving reasonable notice) once the service has outlived its usefulness.

Fee Structure:

Factoring fees vary significantly across the industry and are usually dependent on
a) the financial strength of your customers
b) your monthly volumes
c) the duration of your contract and
d) the payment cycle of your receivables.

The fee (also known as discount) can be as high as 7% per month for small ticket deals (less than $30K per month) to as low as a couple of points for companies that wish to factor several hundred thousand of dollars.

Level of Service:

A very important criterion when selecting a factoring company is choosing a company that will give you the appropriate level of service. The industry is very diverse, and there are many factors that charge very low fees and provide a very impersonal mass approach to service. Conversely, there are factors that provide a high touch level of service, for slightly higher rates. Most companies tend to choose the factor with the lowest rates (and usually lowest level of service) thinking that they will save money. In the long run, they end up regretting the decision. You are usually better off looking for a factor that offers a better service, even if it comes at a slight premium.

Should you work with a factoring broker?

One way to simplify the process of selecting a factor is to work with a factoring broker. A good broker will help you determine if factoring is the best solution for your company and will help you find the factor that is best suited to serve you. The broker will also help you position your company to a factor in the best possible way, maximizing the chances of getting the funding your company needs with the best possible terms. One of the most significant advantages of working with a factoring broker is that they will help you save time. As seen in the previous section, the process of evaluating a factoring company can be both tedious and time consuming. A broker can help you sidestep the issue since they will do all the work of finding the best factor for you. Lastly, most factoring brokers are compensated through a finders fee by the factoring company, so you will not have to pay them any fees for their service.