One of the single biggest small business killers I know is a tight cash flow. Young companies, and even more established companies, sometimes face challenges that require a short-term influx of working capital. I recently spoke with a business owner who needed extra cash to ramp up for a new project, but wasn’t able to secure the funds from his local banker and had to start looking elsewhere. Fortunately for him, there are a number of options available to small business owners who are pinched for cash to ramp up for a new contract, buy a new piece of equipment, or other emergency needs.
Factoring has been around for a long time. In a nutshell, factoring is a financial transaction where a business sells its accounts receivables (AR) in the form of a cash advance. The “factor,” the party purchasing the AR collects the receivables, deducts the agreed-upon fees, etc., and pays the balance back to the business.
Factoring isn’t a loan. The factor is less interested in the credit worthiness of the small business owner, and more interested in the credit worthiness of the small business’ customers. In non-resourse factoring, the factor assumes the liability of the AR, but this isn’t always the case. In the United States, if the factor does not assume the credit risk and is unable to collect, the court will re-characterize the transaction as a secured loan. You’ll want to make sure you understand all the terms and conditions associated with factoring before you sign on the dotted line.
Factoring’s origins lie in the financing of international trade and is said to have started in the ancient world. The Europeans were factoring AR prior to 1400 and came to America with the Pilgrims. Although the concept has evolved over the years, there are basically three parties directly involved:
- The person who sells the receivable
- The customer of the seller (the account debtor)
- The factor
Many small business owners turn to factoring when their cash flow doesn’t meet their immediate working capital needs. However, there are some industries, like textiles and apparel, that use factoring because that’s the historic method of financing their businesses.
Factoring has grown in popularity as banks and other traditional lenders tightened up the money supply making traditional financing problematic for small business owners over the last few years. Invoice financing is relatively easy to get, although it’s more expensive than traditional financing, Nevertheless the terms are less restrictive and the funds are available much more quickly—making it an attractive option for many business owners. As more and more alternative lenders have entered the market in recent years, the cost of factoring and other funding sources is getting more competitive. I think this is a good thing for small businesses who aren’t able to secure the financing they need with traditional methods for short-term cash flow requirements.
There are a number of choices beyond the local bank that offer financing options designed for small business, factoring is one of them. If you’d like to see any options that might be available for your business, completing a Lendio profile will show you the options that might be a match for your small business financing needs.
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 also shares his passion for small business every week on Forbes.com.