Factoring is a form of financing in which a business sells its receivables to a third party or "factor company" at a discounted price. Under this arrangement, the factor agrees to provide financing and other services to the selling business in return for interest and fees on the money that they advanced against receivables invoices. Businesses in need of cash can thus secure up to 80 percent of the receivables' face value (a higher percentage can sometimes be secured, but in most instances 20 percent is held in reserve until the account balances are paid off).
Factoring is a favorite capital raising choice for established small business owners. "A factor company can be a useful source of funds if you are already in business and have made sales to customers," indicated the SBA publication Financing for the Small Business. "Factor companies purchase your accounts receivable at a discount, thereby freeing cash for you sooner than if you had to collect the money yourself." Factor companies can either provide recourse financing, in which the small business is ultimately responsible if its customers do not pay, or nonrecourse financing, in which the factor company bears that risk. Factor companies can be a useful source of funds for existing businesses, but they are not a realistic "seed money" option for startups because such businesses do not yet have a base of customers—or accounts receivable—to offer.
In some respects, the factoring process is roughly comparable to credit card arrangements. "Just as Master Card buys a retailer's receivables, paying the store as soon as a sale is made, factors do much the same on the wholesale level," one executive told Mark Stevens, author of The Macmillan Small Business Handbook. "Assume a manufacturer of wool hats ships a $50,000 order to one of its customers. Rather than waiting for the account to pay, the manufacturer can sell the receivables to a factor, receiving up to 85 percent of the total as soon as the goods leave the shipping dock. This speeds the collection process. The balance is paid when the factor collects from the customer."
Small business owners should be aware that factoring is different in several fundamental respects from bank financing. For one thing, noted Mike Willis in the Tampa Bay Business Journal, it is more expensive. "Costs usually represent 2 percent to 10 percent of sales," he reported. "Fees deducted from the balances paid to you [the small business owner] include a finance charge, which may run 1 percent to 5 percent above the current prime rate, and a service charge that is often a function of the daily balance outstanding, increasing as the balances age. Arrangements for fees vary widely, depending on the credit quality of your customer account balances and the range of services that you are purchasing from the factor." In addition, small business owners should recognize that utilizing a factor company is an all-or-nothing proposition. As Mark Stevens noted in The Macmillan Small Business Handbook, "Factors demand 100 percent of a client's receivables. They will not limit their efforts to those receivables considered marginal or high risk."
Factor companies are an increasingly mainstream choice for small business owners seeking capital. The volume of business handled by factors increased from $60 billion in 1993 to $80 billion in 1999. Indeed, even though factoring carries some risks for small enterprises, it is regarded as a viable short-term cash management tool. "If you take into account the costs associated with maintaining accounts receivable, such as bookkeeping, collections, and credit verifications, and compare those expenses against the discount rate you'll have to apply when selling them, sometimes it even pays to utilize this financing method," said the Entrepreneur Magazine Guide to Raising Money. "In addition to reduced internal costs, factoring also frees up money that would otherwise be tied to receivables, especially for businesses that sell to other businesses or to the government where there are often prolonged delays in payment that factoring could easily offset. You can then turn around and use the money to generate profit through other avenues of the company." But factor companies should be selected with care; some factor companies have been known to alienate customers through excessively aggressive collection policies.
SELECTING A FACTOR
"Selecting a factor is much the same as selecting any other service provider," said Willis. "Find the best price for the services provided." He pointed to several considerations that should be weighed by the small business owner in making fee arrangements with a factor:
* Recourse—Small business enterprises that elect to go with a recourse factor (in which they bear final responsibility for collecting monies owed) over nonrecourse factors (where the factor company bears that responsibility) will find that they may gain lower fees and more money from the factor in return for increasing their risk.
* Customer Base—"The larger the number of customers, the more cost advantages the factor can provide," Willis stated. "Automation gives factors significant economies of scale in this area. Creditworthiness of customers is a fundamental element in factor pricing. Factors will not purchase substandard customer balances."
* Size and Age of the Average Invoice—Smaller receivables that have been on the books for a while will result in less advantageous factoring arrangements for small business owners than will large, current receivables.
* Factor Preferences—Some factors tend to work with larger businesses, while others concentrate their efforts on smaller enterprises. Tampa Bay Business Journal reported that large factor companies tend to focus their attentions on companies that have at least $10 million in annual sales, while smaller factor companies—sometimes known as "re-factors"—may provide services to companies with annual sales as low as $300,000.
* Industry Knowledge—Most factors that reach agreements with small businesses will have a fairly solid understanding of the industry and competitive environment in which those businesses operate. Such factor companies can provide help to small businesses in determining who they should (and should not) extend credit to. In addition, factor companies can be helpful in settling upon credit limits for both new and existing customers. "Assess the factor's understanding of your industry to get the most for your money," counseled Willis.
* System Compatibility—Willis noted that most businesses in today's environment have implemented automated processes to calculate and monitor accounts receivable and cash applications of cash received. Small business owners should make sure that their systems are compatible with those of the factor before agreeing to a factoring arrangement.
* Collections—As indicated above, this can be a tricky area for the small business owner. Handing over collection duties to a factor company is expensive, and over-aggressive collection efforts on their part can damage a small business's relations with legitimate clients. But Willis pointed out that factor companies also often have better luck in collecting monies owed than do small business enterprises, which have limited resources that they can allocate to the collections process. Business owners should recognize, however, that the factor is only interested in business transactions in which their client is owed money. Factors will not be responsible for non-payment that is attributed to other issues, such as vendor disputes or defective merchandise.
A variety of institutions, including bank subsidiaries and finance companies, provide factoring services. These companies can be found via several different methodologies. The Edwards Directory of American Factors provides information on many factors. The Commercial Finance Association offers a list of its members and their service offerings online at www.cfa.com. Another source of information is the Commercial Finance Group, on the Internet at www.comericalfinancegroup.com. Many factoring businesses also advertise in local yellow pages under such headings as "factors," "financing commercial," "accounts receivable financing," or "billing service."