Factoring your receivables enables you to obtain immediate cash to operate your business, without waiting 30 to 90 days, or even longer, for your customers and other creditors to pay down their invoices.
But when entering into a factoring arrangement, as with any contractual relationship, it is important to understand the issues and requirements contained in the contract before you sign it. Some of these issues can be problematic unless you are clear about them in advance. This article discusses some of the key issues that you should consider before signing a factoring agreement.
Understand the Factor’s Fee Structure
Perhaps the biggest single issue is the fees you will be paying for the factoring service. Factoring fees tend to vary widely, and it is important to know not only what the fees are but what you are getting for them.
Most factors charge a percentage of the amount of the invoice.
Most factors charge a percentage of the amount of the invoice they are factoring. You need to know the discount rate, the advance rate and any setup fees that are involved. Factors do not use your credit history when they determine whether or not to work with you. But they do look at your customers’ creditworthiness and your total accounts receivable in determining your fees.
In going over the contract, you should make sure that the initial payment percentage, the discount rate and any other fees are specified. Be sure that the timelines for final payments on your accounts receivable are also contained in the agreement.
Some factoring firms may offer low-ball introductory rates or fees that are well below those of the industry as a whole. That should raise some concern. You should find out if there are any additional fees or requirements that could go into effect after the start of the contract. For example, many very low initial rates are accompanied by monthly minimums or even “inactivity fees.”
If you sign a contract that requires a specified minimum amount of activity, be sure that you have sufficient business and that you generate sufficient invoices to fulfill that minimum.
The Term of the Contract
The stated term of the contract is also a critical component of the factoring agreement. At the outset, if you are new to factoring, or if you’re looking for a new factoring firm, you might wish to limit the length of the contract. If you don’t know the factor, a long-term contract may be detrimental if it turns out that the relationship is not the right one for you. In that case, you should probably keep your options open so that you don’t get locked into a long-term contract with the wrong factor. Of course, once you have some positive experience with the factoring firm, you can implement a longer-term arrangement later on.
Are There Any Collateral Requirements?
Collateral is a third important issue in a factoring agreement. The factor’s decision on whether to work with you, and their fees and advance rates, depend on the creditworthiness of your customers. However, collateral might be required in some cases, for example, if you are requesting a higher-than-usual advance rate or would like help with trade finance.
Or collateral might be required if the credit history of one of your customer’s is weak but you still want to factor those invoices. In that case, you may be required to put up some collateral to guarantee repayment of the advance in case the customer does not pay. Some types of collateral that might be required might include a direct pledge of a stock portfolio or real estate.
Recourse or Non-Recourse
Your contract should specify whether the factoring is being done on a non-recourse or recourse basis. If you want the factor to provide credit protection for your receivables in case the customer doesn’t pay, then you will specify that the factoring be done on a non-recourse basis. That can cost you extra in fees, but it will relieve you of the collection problems.
Have an Attorney Review the Contract
If you’re new to factoring, or if you’re switching factoring firms, it’s a good idea to have your contract reviewed by an attorney experienced in dealing with financial firms. From their experience, they will be able to spot potential problems that you may not have considered.
For example, your attorney will be able to determine if there are any hidden fees in the fine print. Or he can help you decide on whether or not you need certain value-added services that would add to the overall cost of the factoring.
Factoring is an important service that can help you meet immediate working capital needs and other financial obligations. But when contracting with a factoring firm, it is of the utmost importance for you and your attorney to understand all of the issues involved, and to insist on changes, if necessary, to assure your firm’s financial well-being.