When a business owner considers the need for a loan, many times the initial thought process begins something like this: “I need money for ____. How much do I need? How fast do I need it? Can I qualify for the amount I need? Do I want to go through the process of finding out if I’m even approved, little less the time it takes to actually get the money? How much is it going to cost me?”
On the opposite end, the lender is thinking: “Am I comfortable giving this business money? How comfortable am I? What security do I have in place to ensure I’m going to get paid back? What security do I have in place if I don’t get paid back? How much revenue do I need to generate to mitigate that risk?”
The result is a laundry list of questions, answers, facts, and uncertainties. Somewhere in the middle, a lending relationship is to be born.
Unfortunately, in recent years, most business loans are declined. Why? The big picture just doesn’t work for either party.
The same goes for factoring accounts receivable, or AR financing. While factoring providers tend to be more lenient than traditional lenders, factoring accounts receivable is still based on the big picture.
When factoring accounts receivable, these questions are often asked from a client who has been previously turned down by their bank for a business loan. “I have bad credit, can I get approved? My business dipped in sales last year, is that ok?”
The answer is “maybe.” But, let’s look at the big picture.
From a business’ point-of-view, factoring accounts receivable is based on the following pieces:
Invoices Serve as Collateral: A business may need working capital for a variety of reasons, possibly for covering payroll or other expenses. Or, a business may need more working capital to grow their business by taking on more work and for more customers. Therefore, if a business has invoices that it can use as collateral, a factoring relationship can be a good fit for financing.
Initial Funding and Ongoing Monthly Financing Needs: A business should analyze its current AR Aging to determine a dollar amount that would be available to submit to a factor for immediate financing, and then what can be submitted to a factor on a monthly basis for continued financing.
Net Payment Time: When analyzing AR Aging, keep in mind that most factors will not accept invoices past 90 days due. Even the 60-90 day bucket can be a stretch. Most likely, any invoices that are current or less than 60 days out will be in the best position for factoring.
Bottom Line: When factoring accounts receivable, a business will need to consider that a factor will be purchasing the invoices at a discount, typically up to 90%. In addition, a factor will charge an average 2% per 30 days that it takes to collect on an invoice. A business would need to consider this bottom line impact before factoring.
From a lender’s point-of-view, factoring accounts receivable is based on the following pieces:
The Customer: The purpose of accounts receivable financing is to provide a business funding based on invoices due from the business’ customer. A factor will need to details regarding the customer’s business strength and payables process.
The Customer’s Payables Process: A factor is purchasing a business’ invoices and will be collecting on the invoices as if they are its own. Therefore, there is a necessity to understand how invoices are submitted, approved, and paid, and the factor must feel comfortable in the solidity of the process.
The Business Owner: A factor will take all credit, background, and criminal history into account. While an owner’s personal bankruptcy may be overlooked, for example, a history of problematic collections with personal vendors may be a deal-killer.
The Business’ Other Lending Obligations: A factor may want to ensure that it has priority over a business’ accounts and accounts receivable as collateral, and will issue a UCC filing or asset lien, to legally cover this collateral. If the business has an equipment or building loan with another lender, the factor may require an intercreditor agreement with the other lender(s) to divide priority over collateral.
Factoring accounts receivable can be a great way for a business to generate working capital, but like all areas of commercial finance, the pieces still must fit together to create a beneficial lending relationship for all parties.