Factoring has been around for a long time. It’s how the early explorers financed their travels to the new world and how the ancients funded their caravan expeditions into the far east. It’s one of the oldest financing methods available. What’s more, in some industries (like textiles) it’s still the financing vehicle of choice.
In it’s truest form, factoring isn’t really a loan as much as it is the sale of an asset. In Accounts Receivable (AR) factoring, the small business owner is selling his or her AR to a factor, who then collects from your customers. You get a percentage of your receivables up front and the balance (minus what the factor takes) when the invoice is collected.
In years past this was always considered a financing measure of last resort, but over the last few years it has become more popular as traditional financing from banks and credit unions has been harder to come by.
Depending upon your customer base and the state of your AR, factoring your receivables is usually much easier and faster than a conventional loan. What’s more, the factor is more interested in the credit worthiness of your customers than whether or not your credit is perfect. That’s not to say they aren’t interested in your credit rating—every “lender” is interested in that—but they’re more interested in your customers. In fact, some factors specialize in specific industries and business types, so if you’re looking for a factor, it’s a good idea to find one that specializes in what you do.
You’ll usually end up selling your AR at a discount of between two to five percent, depending upon how easy or difficult it will be for the factor to collect. Expect to negotiate the terms based upon:
- Your customer’s past payment history
- The volume of invoices
- The average invoice size
- The average number of days until payment
You can choose whether to sell all your invoices or just some of them to the factor. However tempting it might be, the factor doesn’t want your customers who are traditionally slow, he or she will want to buy those invoices that are most likely to get paid on time.
There are two types of factoring options you should be aware of:
- Full Service Factoring: The factor assumes full responsibility and control of collecting the debt—even if the customer never pays the invoice. The factor assumes all the risk. Of course, this type of factoring carries with it a higher discount when they purchase your AR.
- Recourse Factoring: If your customer doesn’t pay the invoice, you are obligated to buy it back. Recourse factoring allows you to sell your AR at a small discount and is great if your customers have a history of paying on time.
Factoring allows you to leverage your AR now to fill a short-term need for capital. For example, if you sign a new contract that will substantially help your business, but you need some cash to gear up to fulfill the contract, factoring might be a very good way to acquire the capital you need but don’t have within your cashflow. I mentioned earlier that this is the way the textile industry finances getting their products into department stores.
When looking for a factor, be aware that they are not all alike. Interest rates and terms can vary. It’s easy to find this type of financing online, in fact there a number of AR factoring companies on Lendio. It’s also a good idea to check with your bank, many of them do AR factoring, or someone in your industry to see if there is a particular factor that is familiar with what you do.
Small business evangelist and veteran of over 30 years in the trenches of Main Street business, Ty makes small business best practices, tips and advice accessible by weaving personal experiences, historical references and other anecdotes into relevant discussions about leading people, managing a business and what it takes to be successful. Ty writes about small business financing and other best practices for Lendio, in addition to sharing his passion for small business every week on Forbes.com.