Entrepreneurs are, by definition, dedicated to growing their businesses. But for a young company, growth presents the greatest monetary challenge, especially during the first five years. As a company expands, more assets are tied up in working capital, payroll, advertising and facility costs. During these early years, small business owners must have access to both short-term and long-term capital.
The average small business requires between 40 to 60 cents on the dollar to fund new growth. That money is needed for expenses that deplete cash in any business: materials and/or merchandise, labor/payroll and accounts receivable. If a business has a chance to grow $200,000 during the course of a year, it will take $80,000 to $120,000 to support the cash flow (working capital) requirements. Where does a business owner get the money?
Many evolving businesses make two key mistakes involving short-term capital. The business owner often has a great concept, and maybe even a great business plan and experience in the industry. Still, businesses often fail due to a lack of immediate capital or because the business owners took too much company profit for personal use. Eighty percent of new businesses fail from lack of cash flow, not lack of sales.
Balancing the Cash Flow
The entrepreneur’s challenge is to balance the cash and have enough to keep the business owner and the business happy, healthy and in the flow.
When a young and emerging business needs cash for working capital, the owner can turn to five places: personal liquidity, family members, outside investors, banks or factoring.
When a business owner depletes personal resources and wants to avoid giving control to an outside investor, a bank or factoring company is the next place to turn. Thanks to societal conditioning, most business owners will first visit a bank. However, banks have more requirements and regulations, making it harder for entrepreneurs to secure financing.
For the astute small business owner who discovers factoring as a financial solution, her business will gain access capital that can fuel the business without the collateral obligations and traditional loan debt. How do businesses know and understand what factoring is and if it is the right fit?
What is Factoring?
Factoring provides a complete financial package that combines working capital financing, credit risk protection, accounts receivable bookkeeping and collection services. A business sells its accounts receivables to a factoring company at a discount, providing immediate access to capital instead of waiting 30 or 60 days for a customer to pay an invoice. A factor purchases the company’s invoices, pays the business upfront and collects on those invoices from the customer — unlike a bank loan that has to be repaid in regular installments. Factoring is not a loan. The factor purchases the invoices, and the business does not have to repay the factor.
Instead, the customer pays the invoices by the due date as usual but sends checks to the factor’s address. The cycle repeats as cash is needed. The factoring company collects a processing fee or percentage for the service, usually between 2% and 4%, and offers collection services and credit management of the receivables. A business can get cash for invoices quickly and move on with sales.
How Factoring Works
To keep it simple, let’s use an example with money. A business wants to factor a $10,000 invoice. A factor will advance a percentage upfront and hold a percentage until the invoice is paid. For this example, the factor advanced 90% of the invoice ($9,000) right away. The factor holds the remaining $1,000 in reserve until it receives payment from the customer 30 to 60 days later. The invoice will be paid in full directly to the factor, and a fee against the invoice will be determined. For our example, let’s use a 3% ($300) fee deduction based on the $10,000 original invoice. The fees will be taken from the 10% reserve, and when the invoice is paid, the factor releases the $700 balance back to the business. As a result, the business paid $300 to get the immediate use of $9,000.
A business can choose to factor as little or as much as it likes, depending on when it needs or wants the money, which provides access to instant cash. It can accept new orders it may have had to walk away from, take advantage of vendor discounts, meet payroll and tax obligations and grow without the impact of cash flow constraints that previously may have prevented the business from realizing its true potential.
A friend of mine recently reminded me, of all people, that factoring is the easiest form of financing to justify because you can add the cost of the factoring fee to your sales quote and let your customers pay for it. If the average factoring fee is 3%, increase your prices by 3% and don’t lose earnings. The fees could be added into price quotes at a rate of one and a half per cent every six months to soften it up, as cost increases are a natural part of doing business.
Helping a Business Grow
Last year, I visited Joe Marcolongo, a client who originally called me in a bit of a panic looking for financing. He signed up for factoring, and now his company is thriving. He excitedly said, “Factoring is the bomb!” His wife and business partner, Tammy, sat next to me smiling. They had just returned from a week-long vacation and were planning a trip to the shore, then off to the Bahamas!
I was renewing their factoring line, adding more money to their facility as they outgrew their contract once again. They own a staffing business for the transportation industry, which they started two years ago. Joe and Tammy have 140 employees now and swear they could not have reached this level of success without factoring. They started the business with enough cash for 10 employees to last two weeks, and the business exploded.
“I hired office employees to run my payroll and dispatch, opened four offices and I am opening another one next week. Now I always have cash to treat my family the way I always wished I could. All thanks to the cash available with factoring!” he said. If he hadn’t signed up for factoring, he still would have grown the business, but nowhere near the level it is today.
Expanding Customer Terms
Another customer helped cash flow by expanding his customer terms. This manufacturer was making couplings, buying metal, forging it and selling it to machine shops. Its existing customers were extending payments by 15 days because of the recession, so the manufacturer was paying vendors late. I quickly saw his problem with the 15-day payment extension. I suggested he offer his customers a new option, 60-day terms with a slightly higher price to accommodate the factoring fees. Seventy-five percent of the company’s customers accepted the higher rate for the extended terms and didn’t mind paying more for the peace of mind. The manufacturer didn’t lose money on profit margin because he was passing the factoring fee along to the customer. It was a win-win scenario in the middle of a recession, which made the manufacturer look strong because he had the right solution for the times.
An organic baby food manufacturer was not keeping pace with its orders until it started factoring receivables. It was a young company and had a proprietary product that was innovative and unique: baby food packaged to go in squeezable pouches. The market went crazy for it. It hit close to home for me as I had a nine-month-old baby boy at home. The manufacturer had orders rolling in, but bills had to be paid before it could ship more orders. The company was stalling on sales because of cash flow. Factoring accelerated growth by taking cash from receivables to fulfill the existing orders, turning all new invoices into cash in 24 hours and growing the business by 200% in less than 12 months. Before factoring, this company was walking away from $500,000 in monthly orders. Factoring provided the cash needed to double, triple and even quadruple production. The capital enabled it to hire the workers, drivers and supply chain help it needed to get more product on store shelves swiftly.
Solving Seasonal Business Issues
Sometimes it is necessary to have significant cash, but for short periods. In 2005, I started working with a farm that needed $2 million for two months so it could pay temporary employees to harvest the crop. Because the farm had tax filing extensions, the bank could not renew its credit line. The sale of New Jersey sweet corn to local supermarkets’ generated invoices, but these were not paid quickly enough to pay daily workers. Anyone who has worked with daily workers knows, if you don’t pay them one day, they will not show up for work the next. This was truly a day-to-day cash need.
As corn was delivered to supermarkets and invoices were generated, the invoices were factored and for two months a year, the business had the advantage of the factoring line. The company thrived, expanding its growing fields. For the next several years, the farm utilized factoring and continued to harvest the crops on time and keep the fresh Jersey sweet corn flowing to local super markets.
Before considering factoring, answer this question: If your receivables turned into cash tomorrow, what would you do with the money? If you would put it in the bank to earn interest, this form of financing is not a good fit. Factoring provides working capital quickly to spur business growth.