Factoring: It Worked for Columbus
Is factoring right for my small business?
Factoring is one of the oldest means of financing in the world. It financed the exploration of the new world and the Europeans were factoring accounts receivables (AR) as early as 1400.
Like its cousin the Merchant Cash Advance, in it’s truest sense factoring isn’t really a loan. A factor assumes the liability for your AR and is really more interested in your customer’s creditworthiness than your own. In what’s called non-recourse factoring, the factor assumes all the liability for collecting the debt, but in the U.S., if the factor doesn’t assume the credit risk and is unable to collect, the courts will re-characterize the transaction as a secured loan and the burden to collect the debt will fall back in your lap.
Before we can really talk too much about factoring, it’s important to identify the parties involved in a factoring transaction:
- The small business owner who sells the receivable
- The customer of the seller (the account debtor)
- The factor
Factoring is still the financing vehicle of choice in many industries like textiles, but in the past many businesses looked down their nose at factoring. Fortunately for many small business owners who are unable to find success at the local bank, factoring doesn’t carry the same stigma it once did.
Much like an MCA, I consider factoring a short-term source of financing. In a nutshell, a factor buys your AR at a discount. He or she will immediately pay you a percentage of the discounted AR and pay the balance, minus the discount once the debt is collected from your customer. Because the factor is purchasing your AR, they are more interested in the likelihood they’ll be able to collect from your customers and are less interested in your creditworthiness. This makes factoring attractive for business owners with less-than-perfect credit but a healthy AR.
Many factors specialize in particular industries. A factor who specializes in your particular industry will likely have a greater understanding of how easy or challenging it is to collect from customers like yours. This can also be valuable information to you in the future, giving you greater insight into the potential payment history of your own customer base.
Factoring could be a good fit for your company if your AR is stretched and causing you cashflow problems. It’s also a possible way to acquire funds to take advantage of a special offer or profit opportunity. If you find yourself spending a lot of time in collections or need quicker access to some cash to take advantage of supplier discounts, factoring could be an option.
If factoring sounds like something that might suit your situation, there are a few questions I’d want answered before you sign on the dotted line:
- Does the factor have expertise working within my industry? This could be a potential deal-breaker for me. I’d prefer to work with someone familiar with the credit practices within my industry, is familiar with working with customers like mine, and already knows the best way to approach my customers.
- What is the cost of factoring my AR? Every factor is different, so don’t expect they will all charge the same. Make sure you understand all the fees and the terms before you pick the factor you’re going to work with.
- Will they show me references? Let’s face it, if I was going to factor my AR I’d want to ensure that my customers wouldn’t be hounded or treated poorly. I’d want to speak with someone who’d used this particular factor before to get a sense of what my customers might experience.
If you’re able to find a factor that is familiar with your industry, offers favorable terms, and is someone you want to work with, factoring can be a good way to access cash quickly. What’s more, the bank that turned you down for a traditional small business loan may be willing to act as a factor.
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