Factoring Finance

In tough economic times, loans can be hard to find, especially for start-ups and struggling companies. But if a business has customers with reliable payment histories, another source of financing is available: factoring, or trading invoices for cash.

At its root, factoring is not terribly complicated. Three parties are involved: a business, a debtor, and a factoring company. The business provides a product or service and issues an invoice to its “debtor” or customer. The factoring company (or simply the “factor,” an old synonym for “agent”) buys the invoice from the business and eventually collects on it from the debtor.

Factors generally buy invoices in two installments. They initially advance a percentage of the invoice: 75 to 85 percent is normal, but advances as low as 50 percent and as high as 95 percent are not unheard of. The balance of the invoice is held in reserve until the debtor pays. Factors make most of their money by subtracting a fee from the reserve, usually 1 to 3 percent of the total invoice. Terms normally dictate that the longer the invoice is unpaid, the larger the fee.

A simple factoring deal might look like this: the factor advances $800 on a $1,000 invoice, then charges 3 percent if the invoice is paid within 30 days, with the fee going up 1 percent every 10 days after that. If the invoice were paid promptly, the factor would keep $30 from the $200 reserve and send $170 to its customer. If the invoice were paid after 50 days, the customer would see only $150 of the reserve.

Factors would not, of course, be in business for the occasional $30 to $50, so they normally require a 6- to 12-month commitment from their customers. A few companies offer factoring in the short-term, also known as “spot” factoring. Their deals, however, usually involve invoices that total $10,000 or more.

How do factors avoid invoices that are unlikely to be paid? They thoroughly evaluate the credit and payment history of every potential debtor, and they adjust their fees accordingly. Super-reliable debtors mean large advances and low fees, while risky debtors mean small advances, high fees, or even outright rejection. This attention to debtors is what allows factors to work with businesses that don’t qualify for bank financing. When factors examine an invoice from a reliable debtor, “they see an asset that banks usually ignore,” says Karen Turnquist, CEO and president of PrinSource Capital, a factoring firm in Minneapolis.

But factoring companies don’t disregard the finances of their potential clients. While they do not expect to see stellar or even decent balance sheets, they want to work with companies that have at least a promising future. “It’s not good for anyone if a factor partners with a company clearly headed for bankruptcy,” notes Brian Van Nevel, co-CEO of Spectrum Commercial Services, a factoring and asset-based lending firm in Bloomington.