What Every Banker Should Know About Factoring
Every Banker, Commercial Lender and Finance Professional should understand a few of the basics of the factoring industry, as factoring can be a very important tool for start-up businesses, businesses experiencing high growth and those businesses that are having a challenging time obtaining traditional bank financing. As each situation has its own nuances, any advice provided here should be reviewed for its appropriateness.
What is Factoring?
Factoring is the purchase of accounts receivable at a discount. Factoring is used for those companies that do not qualify for traditional bank financing. Because of the higher risk, Factors require increased monitoring and a higher rate of return. Monitoring can vary based upon the client's industry and particular profile.
How Does a Factor Decide How Much to Fund? and which invoices to purchase?
The factor looks to the credit worthiness of the client's customers (account debtors) in making funding decisions. Credit bureaus, trade and bank checks are all routine. As long as the account debtors are credit worthy and fit within the factor's underwriting parameters, the factor will usually fund against an eligible invoice. A slowdown in the account debtors' payments will quickly erode the amount the factor is willing to advance.
What is the Normal Advance Rate?
Advances are usually 70% to 90% against eligible accounts, depending on the industry, stability and diversity of the client base, and strength of the client. Every factor has their own way to make these evaluations.
I have heard a lot of negative things about factoring, are they true?
Factoring has a mixed reputation. It is more expensive than bank financing and requires more monitoring. As factors are working with clients who do not qualify for traditional financing, they have to be quick about making challenging funding decisions. Frequently, these decisions may seem arbitrary to the client; however, the factor is weighing everything from the potential of fraud to client concentrations. For those clients used to traditional banking relationships, having a funding turned down can be an abrupt shock.
Additionally, factoring is more expensive than bank financing and should not be used unless the client has a sufficient gross profit margin (GPM). If the GPM is too low, the client won't be able to earn or grow their way out of the factoring relationship.
How Does it Impact my Bank's Collateral Position?
The factor will file a UCC-1Financing Statement on accounts receivable and other assets if available. If the bank has a UCC-1 filing on Accounts Receivable and/or includes the proceeds from the sale of inventory on their financing statement, it will have to subordinate to the factor or sign a subordination agreement. If the factor is only factoring a limited number of accounts, it will require a subordination for those accounts.
Why should I refer a Client to a Factor?
There generally three types of clients that Banks refer to factors: 1)Turn-downs, 2)Problem Relationships, and 3)Relationships that the lender only wishes to partially fund. By referring the client to a factor, the Bank can retain the depository relationship until the client matures or recovers sufficiently to return to bank funding. It is common for a lender to reduce their exposure by referring a problem client to a factor, who has the processes and controls in place to fund accounts receivable. Payment plans can be developed between the bank, factor and client whereby a percentage of funds collected can be directed to paying bank debt. It is also common for lenders who are more comfortable with fixed assets, property and equipment, to use a factor to support cash needs.
For those lenders working with small businesses, Factoring can be an essential tool.
What Additional Monitoring Will the Factor Require?
Most factoring companies require the following controls, though some may relax a few depending on the situation:
Lockbox Collection - Payments from customers are almost always directed to a lockbox under the control of the Factor.
Original Invoices - Most factors require original invoices and supporting documentation to be provided in order to make an advance. In some instances they may accept facsimile copies.
Notification to Account Debtors - Almost all factors send a notification letter to each of the client's customers being factored. The Uniform Commercial Code (UCC) requires that account debtors pay the party providing a notice of assignment. If the account debtor pays over the notice of assignment to another party, such as the bank, the notifying party can require that the customer pays twice. In other words, if the company's customer is sent an assignment letter from the factor and it still pays the bank, it will still have to pay the factor and may have to pay twice.
Verification - All factors require some form of verification. It may consist of an online review of a vendor's scheduled payments; it could be a verbal verification of a percentage of the invoices being factored. Factors rely on this information and can sue if the information is incorrect.
How Much Will Factoring Cost My Client?
It varies based on the size of the invoices, concentration levels, number of invoices in a funding, difficulty of processing, perceived risk, dilution and level of competition. It is common to see factoring rates between 18% and 36%. Unfortunately, factors have a number of ways of different ways of structuring their fees, so sometimes comparisons can prove challenging. Here are a few common fees:
Factoring fee - Usually expressed at a rate for a certain period (or bucket) of time. For instance, 1% every 15 days represents 1% for each 15 day bucket. The fee stays the same whether the invoice is paid on the first day or the 14th. So if the invoice is collected on the first day, then the rate is really 365%; if collected on the tenth day it is 36.5%.
Invoice Processing Fee - Commonly expressed as a dollar amount. If the fee is $1.00 per invoice, then 100 invoices constitute $100 in fees.
Wire Fees - These are standard fees, but may be marked-up
Minimum Factoring Amounts - This is a way for the factoring company to maintain its income stream even if the client does not achieve its expected revenue level. The client will keep their preferred rate if they can maintain their sales volume; however, even a minor drop in revenue below the minimum monthly sales can have a huge impact on client costs. For instance, ABC company sells $110,000 of product A monthly. Its factoring company sets a minimum monthly factored revenues at $100,000. If ABC's monthly sales decline to $90,000 monthly, then it will still be charged as if its sales are $100,000.
Termination Fees - Bankers should be wary of factors that require unusual procedures or fees in order to terminate a client relationship.
There are a number of other fees that can be charged. If you are concerned about a factor's fee structure, contact factortree.com.
When Should I Recommend Factoring?
Factoring can be an important tool for your Bank. It can be used for prospects or clients that sell to other businesses on credit and do not qualify for traditional bank financing. By referring a prospect or client to a factor, a depository relationship may be maintained and when the client is stronger a lending relationship established.
When is it Inappropriate to Recommend Factoring?
Do not use factoring in the following instances:
Situations when the factor is unable to obtain a first position on accounts receivable. In a work-out situation, if the lender is unwilling to subordinate its position on accounts receivable, then the factor will be unable to fund.
How Should I Pick My Factoring Partners?
Use factortree.com. We have access to a number of large and small factoring companies and years of experience in banking and factoring.
Factoring By Factortree
Factortree provides access to multiple funding sources for the factoring, asset-based lending and leasing needs of small and growing businesses.
We specialize in bank work-outs and specialized repayment programs.