As a company grows, so do its accounts receivable. Growing pains often involve a shortage of cash, creating inadequate cash flows.
So, wouldn’t it be nice if you didn’t have to wait for your customers to pay you? Actually, that is what factoring does for you; it turns your invoices and your receivables into cash. It is a form of asset-based financing whereby a company uses its receivables as collateral for a loan.
The factoring process, like any other form of borrowing, has both positives and negatives.
First, your accountant or attorney should be able to assist you in finding a reputable factor, the individual or company that will grant the loan. That said, the process might seem somewhat involved and onerous. This is because you are, to a certain degree, giving up control of your receivables.
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In most cases, the factor is looking to your receivables as the sole asset backing its loan to you. It therefore wants every assurance that the receivables on which the loans are based are legitimate and collectible. It also wants to be certain that in the event of a problem, it can get control of your receivables in a quick and efficient fashion.
For this reason, the steps that you have to go through to get the loan may seem a bit of overkill. But, if you consider the situation from the factor’s point of view, it’s more understandable.
Before you get a loan, the factoring company will most likely send a group of auditors to your office to closely examine the accounts receivable that you will be posting as collateral. You can expect this audit to be thorough and exacting.
If the factor feels that your receivables are bona fide, it will offer to purchase them, as well as future receivables, and will advance you a percentage of the total receivables that you pledge as collateral. The percentage depends upon the age of the receivables, how complex the collection process will be, and how collectible they are.
You then will be given some rather onerous-looking and complex legal documents to sign. I strongly recommend that you consult with your attorneys and accountants before you sign anything. Of course, I’m assuming that your advisors will have vetted the factor to be sure that the factoring company has a solid reputation.
Once all of the legal documents are signed, all of your future invoices will be sent to the factor, and they will quickly advance you funds based upon a set percentage of your invoices.
There is one overwhelming positive element to factoring. It is the fact that when your company is in serious need of steady cash flow and solvency, factoring may be the right thing for you.
In fact, many of my clients have benefited from factoring when no other source of financing was available to them. By and large, they have paid off the factors, and are using more traditional methods of financing when needed.
Factoring turns invoices into cash. Therefore, as a smaller company grows and struggles, it no longer has to deal with the in-house financing of its increasing sales. Its cash flow increases accordingly as a result of factoring.
Keep in mind that it’s not the right thing for all growing companies, but it can be a lifesaver under certain circumstances.
The main negative factor, in my opinion, is the relatively high interest rate that you will be charged. It usually is much higher than a straight bank loan.
The other most common negative factor is the amount of paper work and the investment of time that your staff has to go through to get periodic advances on your invoices and accounts receivable.
Why Such a High Interest Rate?
Most conventional banks avoid this type of lending because the entire lending process — from the making of the loan, to the servicing of it, to the collection of it — is rather involved and can be laden with risk for the inexperienced lending institution. For this reason, this type of loan is usually left to professional factors.
The reality that there aren’t that many banks interested in factoring gives the factor a “leg up” and allows it to charge correspondingly higher interest rates.
Added to this is the fact that the servicing of this type of loan is, to the uninformed lender, quite onerous. But, to a factoring company that has the servicing infrastructure and experienced staff in place, it’s business as usual.
Additionally, the typical customer for a factor is usually quite eager to obtain the financing, which gives the factor the opportunity to charge a higher rate of interest.
One Final Caution
If a company decides to take the factoring route, it must absolutely have a well-thought-out business plan that includes budgets and cash flow projections. These projections must include the costs of factoring and must show that the company has the ability to comfortably repay such costs. (See A Great Business Plan: The Key to Raising Capital.)
Factoring has worked out for my clients who have grown beyond the need for a factor and have prospered. In fact, I must say that without this type of financing, some of my very successful clients would not be around today.
So, think about whether your company could benefit from the quick cash flow that factoring provides. Also, think about the costs of factoring and whether or not they are just adding to your company’s financial burdens.
Finally, make sure that you have an exit strategy that will allow your company, at some future point, to pay off the factoring company. This exit strategy should be incorporated into your business plan, and it should include a detailed cash flow projection that comfortably shows how your company will repay the factor and exit from the factoring arrangement.
Factoring can work quite well for your company, but it must be done with much preparation and forethought.
Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at Ted@capitalsourcepartners.com.