Let’s say that Bobblehead Co. makes custom wooden bobbleheads that it wholesales for $10 each. One day, Bobblehead Co. gets a large order for 5,000 bobbleheads from e-Commerce Corp. Bobblehead spends a few weeks, makes the bobbleheads, and delivers them to e-Commerce Corp. on June 1st. Bobblehead is now owed $50,000.
That same day, June 1, Bobblehead gets another large order, this time from Super Co. The problem is that, because e-Commerce Corp. has a policy of paying its bills Net 30, Bobblehead Co. has not received the $50,000 it is owed yet and as such, it does not have the capital on hand that it needs to buy the materials to fulfill its order for Super Co. on time. If e-Commerce Corp. does not pay Bobblehead for another 30 days, Bobblehead will lose its super sale to Super Co.
What to do?
Factoring to the rescue! Factoring is the selling of a business’ accounts receivable to a third party in order to obtain funding now. Often, the money can be received within 24 to 48 hours. In this case, Bobblehead Co. can sell to Factoring Co. the $50,000 it is owed from e-Commerce Corp and get paid right away. It will then have enough money to fulfill its order to Super Co., (and even better, you won’t have to read any more silly made-up company names!)
Whereas factoring was once a sort of exotic idea, these days it is a commonplace way for businesses of all kinds to get the capital they need without having to apply for a bank loan or sell a piece of the company to an investor. Literally billions of dollars in accounts receivables are factored every year whether it’s in professional services firms or truckers using transportation invoice factoring.
Understanding Factoring Players and Terms
Even though the idea of factoring is easy to understand – you are owed money so you sell that “asset” to someone else – factoring is a still specialized way of getting money. It has its own language. Here are the terms you need to know:
Client: You (presumably.) The company that is owed money on an invoice.
Account Debtor: Your client or customer. The one who owes you money.
Accounts Receivable: Money owed to you, generally due within 90 days or less.
Factor: The company that is willing to buy the accounts receivables so as to provide businesses with operating capital.
Advance rate: The amount of money, expressed as a percentage less than the 100%, which you are owed by a customers. This is the amount the factor will advance you on the invoice.
Verification: This is the process whereby the factor verifies that you have in fact provided a product or service for a customer and that the customer plans on paying the invoice.
Discount fee: The fee that the factor will charge you for the service. Let’s say that the factor pays you a 98% advance rate. The other two percent is the discount fee. The discount fee is determined by:
- The amount of the invoice
- The perceived risk involved
- How long it is expected to take to collect the funds, and
- The creditworthiness of your customer (not you, since you do not owe the money, your customer does.)
Reserve: A deposit maintained by the factor. It is used to protect the factor against non-payment should a dispute arise between the client and its customer. The reserve is only sent to the client after the customer has paid the factor the amount owed on the invoice.
As should be obvious, the client does not get 100 cents on the dollar when using factoring. Not only must it pay a percentage of the accounts receivables to the factor, but a reserve is also retained and not received until much later.
Obviously, factoring is not an idea that works for most startups because consistent accounts receivable must be in the pipeline for a factor to be interested. But for those more established companies that do have money owed to them every month, factoring can be a great solution. It can provide immediate working capital for inventory, payroll, improved facilities, projects, anything.
In return for that almost-instant cash, you must be willing to give up some of the money you are owed to the factor, and also be willing to have the company, whose invoice you are selling, learn of the sale; they will be paying the invoice to the factor and not you.
Another nice thing about factoring is that it is a relatively easy and quick process, especially in comparison to, say, getting a bank loan. Indeed, the factor cares little about your credit-worthiness and is really only concerned about the payment history of your customer. If your customer pays in full and on time, you are in business. Usually all the factor needs from you is proof that all services are complete or that all products have been delivered as promised. Once you show that, selling your invoice on that deal should be a breeze.
Factoring makes sense for a lot of different businesses. If yours is a business, for example, where the cash flow varies greatly month to month, maybe it is a seasonal business, then factoring could be a boon for you. It
- Evens out cash flow throughout the year
- Gives you steady working capital
- Covers short term cash crunches
- Greatly decreases the time from when an order is delivered to when the invoice is paid
- Reduces some invoicing issues as the factor will make sure that it gets paid
But despite all of the upside benefits of factoring, the process is not without its risk and downsides, including:
- Lost opportunity: By giving up money later for cash now, a business makes less than it otherwise would. What could you do with that extra money that you will be paying to the factor? That is called the ‘lost opportunity cost’ and should be considered.
- It can be a crutch: Factoring can be a sort of financial crutch, allowing you to put off that day when you can cover your own nut. By bearing down with some frugality, it is possible that you could get through a short-term cash crunch long enough to get paid and even-out the cycle out on your own.
- There is a chance that the client does not pay the factor. In that case, the factor will come after you for the money, which you may or may not have.
- It is expensive. As indicated, factor rates vary depending upon the circumstances. You may get 85 percent of your invoice, you may get 98 percent.
- There is a chance that you and your client may get into a dispute about the amount owed or the product they received. That puts the factor in the middle and effectively ends your relationship with the factoring company.
- There may be an effect on your clients. Will your customers think your business is in trouble because you hired a factor, that is, why are you unable to wait 60 days to get paid? What does that say about your business? It may say nothing, but it is something to consider.
- A related issue has to do with your reputation in the community at large since the old belief was that factoring is for businesses that were poor credit risks and could not get a bank loan. That is less true these days, but again, it is something of which to be aware.
Where and How to Find Factoring Companies
If you decide that you would like to explore the factoring potential of your business, finding a factor is easy. Is really is a matter of doing an Internet search and then doing your homework on the companies you find to make sure they are legitimate and good to work with. One nice thing about this Internet age we are living in is that you do not necessarily need to find a factor in your city. Factoring is easily something that can be done virtually.
Once you find a factoring company with whom you would like to speak, here are the questions and concerns that you should ask about:
- What are the basic fees? How much of your invoice will you be paid upon and what percentage is their fee?
- What are the extra, hidden fees in the contract? For example, is there an initiation fee, a due diligence fee, or a late invoice fee?
- What is the reputation of the company? How long have they been around? Who are their clients? What do people say about them? Do people like working with this company? Are they fair and flexible or rigid and dogmatic?
Factoring can be a smart way to eliminate cash-flow shortages and get an immediate infusion of capital.
By Steve Strauss Steve Strauss is a senior small business columnist at USA TODAY and author of 15 books, including The Small Business Bible.