Factoring: What Every Broker Should Know

By: Chris Lehnes

In times of crisis, it’s vital for brokers to have a thorough understanding of all the commercial lending options available for clients.

Every day, commercial loan brokers are presented with the task of matching their clients with the best lending option for their funding needs. To meet this challenge, it is essential to have a basic understanding of the wide variety of commercial financing programs available. This becomes an even greater feat during the unprecedented conditions the commercial lending markets are now experiencing.

We all are witnessing the impact COVID-19 is having on lenders, as most are tightening their credit parameters, while others are placing an outright freeze on new loans as they assess the impact on their portfolios. Some business owners have been able to bide time with funding from government programs, but those proceeds quickly will be exhausted. The onus is on brokers to be sufficiently informed to help their clients navigate these perilous times. One financing option that is often overlooked is accounts receivable factoring.

What is Factoring?

Factoring is the sale of a company’s accounts receivable to obtain working capital. Factors are typically more focused on the quality of a company’s accounts receivable than the company’s financial performance, which can make factoring the perfect alternative for a business that is struggling to obtain traditional loans but has a strong customer base.

Know the Lingo

A true factoring facility is not a loan, so it pays to familiarize yourself with some of the basic factoring terminology, which differs from lending.

A factoring facility can be structured several ways. While this article will not attempt to describe every nuance of factoring, every loan broker should be aware of a couple key differences between recourse versus non-recourse and notification versus non-notification.

Recourse vs. Non-Recourse

With recourse factoring, if one of your client’s customers is unable to pay an invoice or does not pay in a specified amount of time (usually 60 or 90 days), the client is responsible and must repay the advance received. With non-recourse, the factor takes on the customer’s credit risk (their inability to pay), but the client remains responsible for most other discounts or deductions their customer may take on an invoice.

A recourse factor will often underwrite both the credit of the client’s business as well as that of its customers, while non-recourse factors are usually more focused on the quality of the accounts receivable and put less (to no) weight on the financial performance of the business.

The result of this difference is a non-recourse factor is generally able to accommodate businesses in a weaker financial condition and a recourse factor may carry a lower price.

Notification vs. Non-Notification

A notification factor is one that will contact each of a client’s customers and instruct them to make payments to the factoring company. Each invoice issued will usually include instructions that payments must be made payable to the factor. The factor will also usually make collection calls to the customers.

With non-notification, the factor may use a lockbox controlled by the factor so that checks can be made payable to your client. Non-notification factors may have little to no contact with a client’s customers.

Due to the greater control over the flow of cash afforded by notification, this structure is generally able to accommodate businesses in a weaker financial condition.

Who is a Fit for Factoring?

Your client must be a B2B business with a strong customer base in order be eligible for factoring. Common industries include manufacturers, food producers, distributors, wholesalers and service businesses such as staffing and trucking. Most traditional factors exclude construction and third-party medical accounts receivable companies, but specialists focus on these niches.

Companies that are good candidates for factoring also tend to have the following attributes:

? Annual revenues from $100,000 to $100 million

? Businesses billing for a delivered product or completed service as opposed to collecting deposits or performing progress/milestone billings

? Businesses that need liquidity and cannot afford to wait 30 to 90 days for their customers to make payments

? Businesses whose customers are large corporations, municipalities or other government agencies

? Businesses that have been declined by a traditional lender for reasons such as:

? Being a start-up and/or having insufficient operating history

? Being a fast-growing company that needs more credit than a lender is comfortable extending based upon the company’s history

? Being a seasonal business with erratic revenue

? Companies with historic, current or projected losses

Structure of a Factoring Facility

Terms vary by factor. Contact your funding sources for details on their offerings. Most rates usually consist of an initial advance of 75% to 90% against accounts receivable. Factoring fees (aka discount rates) range from 1% to 3% of the invoice for each month the invoice is outstanding (this may be broken down into five, 10 or 15-day increments). Lower rates are typically reserved for recourse factors with a greater focus on business performance. Some factors charge both a factoring fee as well as an interest rate on funds advanced. Be careful to read the fine print as some factors may include other charges.

Most factoring facility terms range from zero to 24 months and range in size from $10,000 to more than $10 million per month in factoring volume. Different factors are focused on the low and high end of this range.

Many factors require a client to commit to factor a certain volume each month. Some factors set no cap on their facility and will allow fundings to grow as the client’s business grows if they keep selling to creditworthy companies. First lien on accounts receivable will be required (at a minimum), so ask your client early in the process if they have any outstanding liens on their AR. It may be possible to have an incumbent lender subordinate its lien on AR to allow factoring, but success rates are usually low.

The Approval Process

For a non-recourse factor, little information over and above a recent accounts receivable aging and customer list may be necessary to obtain a proposal. The factor will use this information to assess the quality of the customer base. Recourse factors, which perform more of a hybrid analysis, will likely require a standard commercial financing package, including current and historic financials, so they can underwrite the business performance as well as the accounts receivable. Term sheets issued in hours to a few days are common.

The Funding Process

Your client will continue to do business as they always have: shipping products, completing services and invoicing their customers. From there, the invoices will be sent to the factor. For a notification factor, the invoice will include payment instructions to the factoring company. The factor will verify the invoice by contacting the customer. Upon verification, the factor will advance your client 75% to 90% of the invoice — often the same day the invoice is issued.

When the factor receives payment from the customer, your client will be sent the “rebate” (the remaining 10% to 25%, less the factoring fee). Most factors will fund their clients as often as daily, or less frequently as needed by the client. Initial funding under a factoring facility is often in less than a week. Once a facility is in place, funding usually takes place the same day a new invoice is issued.

Use of Factoring Proceeds Most factors put no restrictions on how funds may be used, but a few uses can include:

? Project financing ? Business growth financing

? Business acquisition financing

? Bridge financing

? Financing working capital needs

? Realization of supplier discounts

? Preparation for high season

? Crisis management

? Debtor-in-possession (DIP) financing

Choosing Your Factor

The reputation of your factor matters. Research the company, ask about its expertise, funding source and notification and verification process. How it interacts with your clients’ customers is key.

Hopefully, you can now discuss factoring with prospective clients and ask key questions to see if they are a fit. Contact the factoring sources you trust to leverage their expertise and they will remain essential funding sources for your clients long after this pandemic is behind us.