Factoring companies have been around for ages, and still in everyday life most people have no idea what they do. Simply put, “factoring” is a form of commercial financing or debt financing which has collateral as the basis for borrowing money. In this case, an invoice or obligation to pay by an account debtor is the collateral for borrowing.
Whenever a company provides a service or sells a product to a customer and offers terms of payment, the company is in essence “loaning” money to the customer until it gets paid. This act of making a loan to the customer is commonly known as the invoice. The factoring company makes arrangements to buy this invoice, pay the company immediately and waits for the customer to pay their invoice – back to the factor. There are some principal benefits to this type of financing:
- Speed: Unlike most capital resources, the factoring relationship can be set up in days, and once set up, the funding of an invoice happens within 24-48 hrs.
- Financial: The funding decision is based on the financial quality of the customer, while the factoring client can be financially challenged or just getting started.
- Credit Limit: Generally as long as the client is invoicing a good creditworthy customer the factoring relationship can grow with the client, so there may not be any limits of access to capital.
- Discipline: One of the ways a company can get into trouble with a bank line of credit is lack of discipline – meaning not regularly paying down the line. With factoring each time the customer pays the invoice it retires the mini-loan.
- Equity: Factoring is considered an “off-balance sheet” form of financing which keeps any net term liability off the corporate balance sheet preserving the equity position in a positive manner.
- Set Up: The process of getting started requires minimal paperwork and no lengthy negotiations compared to banks and equity venture funding.
- Cost: The cost of factoring invoices is relative to the short term nature of the transaction – not lasting more than 90 days. So more than a bank but less than a V.C. Companies that have very thin profit margins are not best suited for this type of financing to grow their business.
- Growth: Having access to capital improves the financial condition of a growing company and ultimately leads them to conventional bank financing.
Here is a typical example of how factoring works and why it can be so important to a company that is on the verge of doubling in size:
A company has been struggling to get a large contract for a long time. This has created stress on their finances, getting by until the big contract finally hits – and then it does, congratulations. Now a dozen new hires need to be quickly put in place. Two weeks later comes the first payroll, two more weeks and another payroll, but the invoice is submitted to the customer. With factoring, the next day, access to the capital tied up in the invoice is available to the company allowing them relief from the working capital crisis.
Typically there are three parts to a factoring transaction:
- Advance: The percentage of the total amount of the invoice that the company has access to when they are funded, which is around 80%.
- Reserve: The remaining percentage held back and released when the customer pays the invoice.
- Discount Fee: The fee associated with doing the transaction which gets deducted from the reserve. Based on how long it takes to receive payment of the invoice the fee can be 2 – 5% of the full value of the invoice.
Bear in mind that factoring companies tend to work operate differently, and specialize in particular industries, so it is important to see that you get a good match when seeking an optimum funding relationship.