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Business Owner Financing - Factoring

Factoring is the technique of borrowing using unpaid invoices as collateral. As the financial markets remain in turmoil and conventional lending becomes more difficult to find, factoring will grow.

I have no personal experience with factoring, so I asked a friend with years of experience in the business to write something about it. He is the author of the article that follows. He is also in the factoring business and will be happy to talk with business owners who are interested in checking it out in depth. Send me an email at paul @ y6b.com with your contact information and I will forward it on to him. I promise not to share it with anyone else.

Factoring 101

Things have changed a lot since I first entered the industry.  The main force driving the change has been COMPETITION!  Didn't mean to shout.  Factoring used to be considered a very expensive form of financing, and it actually was.  Today, however, rates have come down substantially due to COMPETITION!  The process itself is very easy to understand.  The complexity of the transaction comes from the Factors side in trying to determine the discount and advance rate.  This is primarily calculated on the credit worthiness of the company standing behind the receivable.

A Factoring firm will look at a request and determine the rate and advance for that receivable.  I usually like to use 3 hypothetical examples. 

Let us say that a local janitorial firm comes to me with 3 receivables they want to sell.  One is for a local company such as Baillo's that they are cleaning.  The next is for the local office of IBM that they are cleaning and the third is for an agency of the State of New Mexico.  I would send the relevant paperwork and I know that a factor would come back to me with 3 quotes.  If each receivable was for $100, I would expect that the Baillo's receivable would be bought for $93, the IBM receivable would be bought for $95 or $96 and the State receivable would be bought for $97. The discount is based upon the risk that a factor feels they are taking on. 

The next variable would be the amount of money that would be initially advanced against the $100 invoices.  The local firm would probably get an advance of $70 and receive the other $23 when Baillos pays.  Again, this is because of the risk involved with going with a small local company.  The IBM receivable would probably get an advance of $80 to $85 with the balance being paid when IBM pays the invoice.  Fortune 500 firms are considered better risks than local Albuquerque firms.  Finally, the janitorial firm could get an advance as high as $90 on the government receivable since it is generally assumed that Government entities have no default risk (Orange County??). 

There are  other tactics that can be used to lower the cost  such as aging a receivable yourself and then selling it, etc,  but that would be getting into too much detail here.

Some of the selling points that all Factors use are things such as:

  • This is not a loan, but a sale of assets of the company.  This provides "off sheet" financing which is highly preferable. 
  • Many times these transactions can be structured as non recourse.
  • Factoring is like having a credit card for the business in that it gives you immediate cash flow once the account is set up.  Normally funded is provided within 24 hours.
  • Gives you more predictable cash flow.
  • Increased profits since cash can be put to work sooner.
  • Allows you to take advantage of trade discounts that often times can offset some of factors discount.
  •  Paying quicker and taking trade discounts also means that you are building credit ratings with suppliers.
  • Reduces your credit risk since the Factor is doing a credit analysis of your customers for you.  If a factor won't buy a receivable, maybe you shouldn't be doing business with that company.