Unfortunately, small business owners often have little time to research all their alternatives properly. They are forced to make a decision quickly. I can help you with that. If you are still not sure of what you need, then read this article first. It gives you a good idea of all your options.
If you have already decided to explore accounts receivable factoring in more detail, then this article will help you. Although I have written about factoring before, I wanted to create a more comprehensive resource to help business owners understand this product better.
Before we delve into the details of factoring, though, let’s consider one important question you should ask yourself. Understanding your answer to this question helps you save a lot of time and, possibly, money.
Why do you need the funding?
The first questions to ask are “What do I hope to accomplish with the funding?” and “What is my objective?”
It’s surprising how many entrepreneurs seek funding without having good answers to these questions.
When it comes to funding, there is seldom a once-size-fits-all solution. Contrary to popular belief, venture capital is not the only answer to your problems. Nor are bank loans, or any other single product. Different solutions can be used to solve different problems. Each product has strengths and weaknesses.
Sure, some products are more flexible while others have a more narrow focus. Again, it all circles back to the main questions:
- What problem are you trying to solve?
- What are you looking to accomplish? and, most importantly,
- Does this product help you get there?
In the case of factoring, the solution is designed to fix a single problem. Factoring is an effective solution, as long as you use it to solve the problem. This point is important.
The problem: Are your clients paying you in 30 to 60 days?
Most commercial and government sales are made on net-30 to net-60 day terms. This means that your startup or small business must wait up to eight weeks before collecting its invoices.
Few startups or small businesses plan for this payment delay when they start. This can be a big problem later on.
Let’s look at the problem. As a small business, you probably need to pay your vendors quickly. Your employees probably get paid weekly or every two weeks. However, your clients pay you in up to two months. As a result, you are using your limited cash reserves to pay for current operations, while waiting for client payments.
If you have no reserves, you are probably delaying supplier payments – or worse – payroll.
Unless you have a cash reserve, these problems get worse as your startup grows. Eventually, you encounter cash flow problems. And if you don’t manage them correctly, you could go out of business. I’ve seen that happen many times.
This problem can be solved easily with a business line of credit. But there is a catch. Getting a line of credit is nearly impossible for startups and small businesses. For starters, banks require a minimum of two years of positive trading experience. Good luck with that.
This is where factoring comes in. Factoring allows you to solve this problem without having to endure the tough underwriting that lenders require. And it solves the problem very well.
What is factoring?
Factoring is a solution that allows you to finance your slow-paying invoices from creditworthy commercial clients. The catch is in the structure of the transaction. Most factoring companies don’t provide a loan or line of credit that requires the backing of your company. Instead, they purchase an asset (the invoice) from you and give you an immediate payment.
The structure changes the risk profile. Since the factoring company is buying your accounts receivable, they are most interested in three things. They need to make sure that your:
- Commercial clients have good credit
- Service/product was delivered successfully
- Invoice is not encumbered by liens
This solution changes everything for a startup. As long as your company is not at risk of near bankruptcy and the founders are free of legal issues, factoring is an option. More importantly – you don’t have to give up equity. Once the factor has outlived its usefulness, you finish the relationship.
How does factoring work?
Let’s divide this process into two parts – account setup and funding. Setting up a factoring accounts takes about a week, give or take a few days. You do this only once – at the start of the relationship.
Each factoring company has a different process, but, usually, you have to submit:
- An application
- A list of client/s you want to finance
- An A/R aging report
- A sample invoice
Once your account is set up, you are ready to start funding invoices. This process is usually quick. Most invoices can be funded in a business day – as long as they meet the factor’s criteria.
Receivables are funded in two installment payments. The first installment – the advance – covers 80% to 85% of the invoice value. Usually this amount is deposited directly to your bank account. The remaining 15% to 20% is rebated, less the fee, as soon as your client pays the invoice in full.
If your client short-pays an invoice, the amounts are adjusted accordingly. For more details, you can learn more by reading this great guide.
Advantages and disadvantages of factoring
Like any financing solution, factoring is not perfect. The solution has many advantages, but it also has some disadvantages. Let’s cover the disadvantages first.
#1 It’s more expensive than a loan
A receivables factoring solution can be more expensive than a loan or line of credit. Depending on your volume of financed invoices, the cost can range from 1.5% to 3.5% per 30 days. Because of this cost, factoring can work only for companies that have good profit margins. Generally, 15% is good, but higher is always better.
#2 It’s not transparent to your customers
This solution is not invisible to your customers. Customers are notified that they need to send a payment to a new address. They may get calls to verify invoices. Most factoring companies do this with your help so that any impact is minimized.
#3 You can use it only if your clients have good credit
The success of the whole transaction depends on the creditworthiness of your clients. If they don’t have good commercial credit, you can’t factor their invoices. But, on that note, if they have bad credit, you should not be extending 30- to 60-day terms either.
Factoring also has a number of advantages, especially for startups and small companies.
#1 It improves your cash flow immediately
The primary advantage of a factoring line is that it can improve your cash flow very quickly. After an account is set up, invoices can be funded in one business day. You can re-use this process as often as you like, as long as your clients/invoices meet the factor’s guidelines.
#2 It can be set up quickly
As mentioned before, most lines can be set up and ready to fund in about a week. And if you have all your documents ready, it can be done even faster. Because of this quick turnaround, factoring can be used to solve a cash flow emergency.
#3 It’s easier to get than most solutions
The underwriting requirements for a factoring line are much simple than those of other solutions. Most companies that apply for factoring can get it, as long as their:
- Clients have good credit
- Invoices are for delivered products/services
- Company is free and clear of legal and tax issues
#4 The line is flexible and grows with your business
The line is designed to be flexible and can grow with your business. Increasing the line can be done in a day or two – depending on your factor. This flexibility can be valuable if your company lands a big purchase order.
#5 There’s no need to give up equity
A factoring company does not demand an equity participation in your company. This can be very important during the initial stages of your business – when it’s still far away from realizing its true value.
# 6 It helps you select better clients
Lastly, the factor checks the commercial credit of your clients and acts as a credit department. The factor can advise you whether a client has a good track record paying invoices, or if they should not be given payment terms.
How to find a good factoring company
The market is full of factoring companies – which is both good and bad. It’s good because it gives you many options. However, it’s bad because it can be hard to differentiate among factoring companies. Consequently, you need to do some due diligence ahead of time.
To find a good factoring company, follow these steps:
#1 Get a few names
An easy way to find factoring companies is to simply search the internet. They are easy to find. Review their websites to get a feel for the companies. Go through this process until you select three or four that seem like a good fit.
#2 Ask them the important questions
Interview each company to determine if it is a good fit for your company. Questions to ask include:
- How long have you been in business?
- How do your processes work?
- Can you provide client references from my industry?
- Are you comfortable working with companies of my size?
- How are you funded?
- Do you offer short-term contracts?
Once you finish interviewing the companies, select the top two and submit an application. If all goes well, you should get proposals shortly thereafter.
#3 Compare proposals
Your last step is to compare the proposals. Determine which one offers the best value – which may be different from the proposal with the lowest cost. If all goes well, negotiate the agreement and get your funding.