Factoring is the act of obtaining funding, generally from a non-bank entity,1 by assigning or selling2 certain present receivables to that entity by a seller – whether a business-to-business and/or a business-to-government enterprise.
In a broad sense, there are two types of factoring deals. In a spot factoring deal, the entity purchasing receivables (also known as the factor) has full discretion over the accounts it seeks to purchase, which, in a spot deal, is generally limited to one large account. Conversely, in a whole turnover factoring deal, the factor takes all or most of the receivable accounts.
In return for the transfer or assignment of these accounts, the factor advances funds to the seller in some percentage of the total assigned receivable value (generally 80% to 90% of the total account value), holds the receivables while the account ages, and remits the balance (also known as the reserve) once it has successfully collected the account in full, minus a fee on the capital deployed.
A company may decide to engage a factor because of its financial situation, its industry’s situation, and/or the economy at large. Companies may use factoring to address seasonal fluctuations, slow-paying customers, rapid growth, insufficient financial track records, and/or inadequate ratios to qualify for traditional lending.
Troubled companies comprise only a small portion of the overall factoring industry, but many people erroneously believe that all firms that factor are out of viable options. Many of the companies that use this form of working capital are in solid financial shape and in need of a financial partner to scale alongside them. Additionally, it is common to see startups, which generally do not have a multiyear financial track record (a requirement for any bank), use factoring as a tool for growth.
Historically, factoring was referred to as lending of last resort, but merchant cash advance companies have shifted into that position, and factors have begun providing capital to healthier/less distressed businesses, all while improving service offerings and reputability.
Factoring can be an extremely complex process, as no two factoring agreements are identical. According to Mark Mandula of United Capital Funding, total global factoring volume in 2019 was €2.9 trillion ($3.451 trillion), and, while lower in 2020 due to COVID-19, the capital form remains vital for businesses across the globe. As an aside, the United States’ annual factoring volume is generally diminutive to that of the EU and China, who together tend to encompass roughly 80% of global annual factoring volume.
The purpose of this article is to provide an overview of factoring by presenting its pros and cons and other aspects for business owners to consider in making the best capital decisions for their respective situations.
The Benefits of Factoring
Factoring can be a lifesaver in helping a business get through times of depleted cash, as it puts less emphasis on underlying business health than a traditional lender. Factors have no need to concern themselves with the credit history of a seller, just the credit of the account debtors (the seller’s customers). With that, a factor will not lose sleep over the health of a seller’s customers in totality, but will worry over the health of the accounts the factor contracts to purchase.
Specifically, factors approach and assess the risk of an engagement by looking into the credit of the account debtors, the diversification of the customer base, and the collectability of the invoices. In contrast, more traditional lenders require a financial track record, ratio hurdles, and debt service coverage (with a cushion), i.e., more than sufficient cash flow to pay interest and/or any amortization. In this sense, factoring can serve as a strategic tool for businesses that do not meet the requirements presented by traditional lenders.
But most factors will avoid going into business with a company that is certain to fail in the near term for two reasons. First, factors would ideally like to retain clients for successful longer-term partnerships, and second, factors are rightfully wary whether customers would follow through on payment obligations if their vendor went under.
Any fairly healthy company (broadly defined as solvent) with a reasonably healthy customer base can sign into a factoring agreement since the structure, covenants, and respective fees are most dependent on the health and credit of the seller’s customers, not the company itself. This sweeping availability of factoring is one of its main pros, but this contrarian focus on the credit health of account debtors is a fact that many companies and advisors remain unaware of.
The turnaround time in a factoring agreement is another major benefit, especially when compared with traditional financing sources. It is common to see factor turnaround times of just a few days versus the months a standard term loan or revolver can take. Many businesses cannot afford a lengthy process of due diligence and collateral testing, especially those in distress and in dire need of cash to make week-end payments that can quickly accumulate into unmanageable accounts payable. Factoring can provide the much-needed cash that can help subdue this potential danger.
Factoring also can eliminate the in-house collections process, at least for those accounts a factor has purchased. Once an account is deemed purchased, it is incumbent upon the factor to collect that account, so the seller does not need to worry about the collection of sold accounts and can solely focus on creating more sales to subsequently factor. With a factor, a seller can, perhaps for the first time, lift its head and tilt the rudder toward more auspicious waters.
In a similar light, factors frequently offer administrative credit management, including but not limited to collection efforts (broadly defined), invoice management, credit and background checks for new and existing customers, and online receivable tracking. Therefore, a factor will often serve as the de facto credit department of a business and, in this role, guide the company away from customers that carry potentially devastating relationships.
Lastly, factoring can be highly effective while operating in bankruptcy court. On some occasions, factoring has been used as debtor-in-possession (DIP) financing, allowing a bankrupt company to operate through the case with the use of cash collateral to fund day-to-day operations. DIP financing allows for added security for both parties in that a purchaser’s facility floats to the top of the capital structure with super-priority status, while the seller will not be forced into a constricting agreement because of the breadth of legal oversight. The caveat with DIP factoring is its rarity; however, this in no way curtails the benefits that a DIP factoring agreement can bring to a company seeking liquidity in a bankruptcy case.
Factoring Comes with “Watch-outs”
As you might expect, obtaining cash in a timely fashion cannot be cheap, even with factoring. The fees attached to factoring, like other forms of alternative financing, can be steep and extensive. These may include a discount fee, service fee, operational fee, over days fee, funding fee, minimum sales fee, closing fee, and many others.
The factor fee — typically 1% to 2% of the invoice amount for each month that it takes an account debtor to pay the purchaser — can become lofty in quick succession. For example, if a seller’s customers are slow to pay, e.g., the seller has an average days sales outstanding (DSO) of 60 days, the seller is losing 2% to 4% of the invoice amount on average, non-inclusive of other fees withheld from the reserve balance.
Additionally, there are circumstances in recourse agreements where a factor may apply a buy-back/chargeback fee on a seller. In the case of a recourse agreement, when an account debtor fails to pay the invoice in full, the seller is contracted to repurchase the receivable account in full or for the balance of the unpaid amount. The toll on the seller here is substantial. They must buy back a delinquent account that may forever be uncollectable while paying fees to do so.
Buy-back provisions and fees exist within agreements to protect factors from a seller presenting uncollectable invoices. In the case that a performing account suddenly becomes uncollectable, the seller must bear the brunt. Simply put, recourse agreements allow factors to obviate the bulk of the credit risk.
In some cases, a factor will place tight restrictions on a seller around the termination clause of an agreement. For example, there may be a stipulation in which the seller is unable to terminate an agreement without the factor’s conditional written approval. This contract can result in a seller being fully contracted to fulfill all requirements set forth in a purchase agreement, no matter the degree of covenants. A contract also may come with a termination fee charged to the seller if a termination, by will or default, transpires.
Another potential pitfall of a factoring agreement is the way in which a factor pursues the accounts. Some factors, having purchased accounts outright from a seller, may feel at liberty to use aggressive collection techniques. In a worst-case scenario, customers may search for replacement vendors rather than deal directly with the unabatingly harsh factor. Customers would likely be quick to alert the company if a factor were practicing unscrupulous collection techniques, although there is the inherent risk that the customer would have been rubbed too far the wrong way. These cases are the exception, not the norm, since it in no way benefits a factor to upset the customers of a client that would otherwise generate future invoices that could, in turn, be factored.
Cash-strapped businesses are generally, and should be, in a rush for solutions. It is essential to note that some (ill-intentioned) factors will look to leverage this. These factors may create extremely complex purchase agreements with adept counsel to conceal language (involving fees, provisions, etc.) or perhaps solely to deter a seller from analyzing the verbiage with a clear mind.
There have been cases in which sellers have signed factoring agreements without the aid of counsel and have found themselves locked into factoring agreements that deepened their state of distress. In the case that the final purchase agreement is of the recourse variety, a seller could find itself battling factors in litigious bankruptcies full of consent judgments and disputed breaches of the automatic stay provision (§ 362 U.S.C. Bankr.). In the case that the initial purchase agreement is of the non-recourse variety, a seller may just end up burnt by the sale, having sold the accounts for far less than their true value and/or paying exorbitant fees attached to the proceeds of the sale or the accounts themselves. Again, these cases are the exception, not the norm.
Finally, the stipulations within some factoring agreements can be restricting for companies seeking this added layer of liquidity. Constricting companies is not the goal of most factors. Factors are, and should be, seeking to best protect their interests, and borrower flexibility will always kneel to lender protection.
After exploring both the pros and cons of factoring, there are some additional items that should be considered when a business contemplates a factoring arrangement.
- There are certain industries that require a specialized factor due to the inherent intricacy of accounts receivables. These industries include but are not limited to healthcare, construction, and transportation. The aforementioned are the most quintessential of industries that factors will avoid due to the intrinsic complication of collecting and valuing accounts. As examples, consider the complexity that insurance creates for hospital billings, and the interplay of contractors, subcontractors, and progress billing for construction.
- The accounting treatment of the two broad types of factoring agreements (recourse and non-recourse) is quite different in practice. In a recourse agreement, if an account debtor fails to make full payment to a factor, the factor can seek the balance in any unencumbered assets of the seller. Due to this ability to reach into the pockets of the seller, Accounting Standard Codification (ASC) 860 (on “Transfers and Servicing”) does not consider recourse accounts to have been duly transferred, so the accounting treatment of a recourse agreement is like that of a secured borrowing (accounts receivable for the purchased accounts remains on the seller’s balance sheet, as only cash and liabilities change, e.g., the factor advances $100,000, which is now a short-term liability that is contingently due to the factor and is simultaneously offset by the $100,000 immediate cash funds). In a non-recourse deal, the accounts are deemed transferred and, consequently, are fully swept from a seller’s balance sheet. These accounts are replaced by (1) the cash advance and (2) the beneficial interest/reserve receivable upon collection, less fees/expenses, which are flushed through the income statement. To best understand the many nuances regarding the accounting treatment of factoring agreements, it is critical that a seller consult a certified public accountant firm that is highly experienced in this arena.
A factoring agreement is generally more expensive than a loan from a traditional lender since immediate cash is often tied to elevated risk, and thus cannot be cheap. Factors charge a risk premium for their cash, as few financiers are willing to lend to distressed and/or nascent companies.
Writ large, without factors, more essential businesses would crash and burn than the amount that do in the currently factor-replete environment. In the counterfactual world without capital sources akin to payday lenders and factors, there would be a dearth of personal and corporate recoveries, and the economy would accordingly be in far worse shape. Factors and the like fill a crucial gap in their respective markets and meet a vital demand for businesses seeking liquidity in the contemporary economy.