Factoring is the process of obtaining funds by selling a business’s accounts receivable to a third party, known as a “factor”. The company receives payment for those receivables instead of waiting until the due date of the invoice (or later) for the customer to pay. When the receivable falls due, the customer remits payment directly to the factor instead of to the company. Because factors essentially extend credit not to their immediate clients but to their clients’ customers, factors are more concerned with the customers’ ability to pay than they are with the financial situation of their own clients. A business that has creditworthy customers may be able to obtain financing using a factor, even if it cannot get traditional financing.
The process just outlined seems straightforward, but there are risks that are not immediately apparent. Any business considering a factoring relationship should exercise caution in researching the factors being considered and the agreement between the parties. Failure to do so can have unpleasant consequences.
The first question businesspeople should ask about a possible factoring relationship concerns the payments involved. In a typical factoring arrangement, a business sells the factor the right to collect the business’s receivables for the face value of the receivables minus a discount of typically 2 to 6 percent. The total payment for any receivable, however, is not made immediately. Rather, the factor will pay the business a lesser amount, usually 75 to 80 percent of face value, and will pay the remainder (minus the discount) when the customer finally pays. The size of the discount, and the percentage of face value paid up front, will depend in large part upon the age of the business’s receivables: the older the receivables, the less the business can expect the factor to pay.
Since factoring shifts the risk of non-payment from the business to the factor, the factor builds this risk into the price it pays for the receivables, and into the manner of the payment. The discount rate factors charge is usually greater than the interest rates charged by more traditional lenders because of the risk factors, so a company’s decision-makers must be certain that they understand exactly what they will receive.
There are also some non-monetary aspects of factoring that might surprise the unwary. First, a business that factors its receivables must notify its customers that they must now remit payment directly to the factor. The factor will also run credit checks on the customers who actually owe the factored receivables, and these customers might not appreciate such an action.
Factors are obsessed with seeing proof of the validity of a receivable. They will require copies of documents showing signatures of authorized representatives of their clients’ customers – and signatures of receiving clerks might not be enough. A factor will generally require the signature of the person who authorized the purchase, and one from someone who can attest that the goods or services purchased were satisfactory, so that the factor can conclude that the debtor intends to pay the invoice. This process often involves multiple checks and balances; for example, a factor may refuse to accept documents that come directly from its clients, as the necessary signatures might not be genuine. The factor will contact the customer directly to acquire the relevant documentation, and any business working with a factor must alert its customers of this possibility. This means the business risks worsened relations with its customers or at least their resistance to cooperating with the factor.
Factoring can be a good way to obtain financing.