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Question

I've heard of the term "factoring" in terms of a potential financing method.  What exactly is factoring and what does it involve?

Answer

Factoring is the name for the process when a company "sells" its accounts receivable to a third-party for a discount and the third party collects the money (see the post below for more details on the process of factoring.)

The positives as I see them:

• It is not debt
• It resolves your cash issue and cash flow crunch when your customers pay you only after you have already sunk your costs into the product or service

The negatives as I see them:

• It is usually fairly costly - in other words, the discount is fairly steep; you may only get 80 to 95 cents on the dollar depending upon the credit worthiness of your customers
• It is often thought of as a "lender of last resort" situation, even though it is not really a loan -- often viewed as done only by a desparate company, which could impact your customer relationship
• You usually end up handing off your customer relationship to a third party that may not treat your customers the same way you would

The following blog post helps add color to the process

Having to wait up to 60 days for commercial customers to pay their invoices can be one of the biggest challenges that owners of small to mid size companies have to face. Waiting to get paid is not usually an issue for well-established companies that have a significant cash cushion in the bank. However, it can seriously affect smaller companies or companies that are going through a significant growth phase.

Most business owners react to this cash flow problem by going to the bank, hoping to obtain a business loan or a line of credit. However, banks have strict lending guidelines and seldom lend money to businesses that cannot demonstrate three years of profitable operations and cannot provide audited financial statements. Furthermore, most bank financing products tend to have arbitrary limits, which are based on your existing financial capacity, rather than your projected growth.

What growing businesses need is a form of business financing that is tied to sales, allowing you to get more working capital, as your company grows. Furthermore, the solution should work for small and mid size businesses that may not have established credit histories, but that have great paying customers. Is there such a solution?

If you are in a situation where your business is growing and selling products or services to great credit worthy customers, you should consider factoring your invoices as a possible solution. Accounts receivable factoring allows you to convert your slow paying receivables into cash, by financing them through an invoice factoring company. Accounts receivable factoring is a flexible line of financing that is directly tied to your sales. Basically, the more you sell to good customers the more financing you can obtain.

The financing process is fairly simple. Once an accounts receivable factoring agreement has been established, you send copies of your invoices to the factoring company, who in turn advances you a significant portion of their value. A small percentage is usually not advanced and kept as a reserve to cover disputes / etc. You obtain immediate funding to pay for company expenses and grow the business, while the factoring company waits to be paid by your customers. Once they get paid, they will rebate the funds that were kept in reserve and charged a small fee for the service.

Accounts receivable factoring is an ideal financing product for companies that are growing quickly and cannot afford to wait 30 to 60 days to receive payment from their customers. It provides you with the necessary financing to operate and grow your business, and as opposed to bank products; it’s easy to qualify for this service.

Source: eVCClub