From Entrepreneur:Say you’re a young startup–growing fast, but with little-to-zero positive cash flow–and you’re straining to reach the next level or just to get through the end of the month. The bank-financing drought is showing no sign of letting up, and of course credit lines are reeled in tight.
What’s the answer? For a growing number of startups, it is factoring. The practice involves a financing company, or “factor,” advancing you money based on its buying your receivables at a discount; your customers pay the factor the full value later, when the bill is due. Factoring gets you cash in hand immediately–but at a steep price. Factoring fees are much higher than interest rates charged by a commercial bank. Fees are quoted by the month, so a typical 3 per cent fee is actually the equivalent of a 36 per cent annual interest rate.
Dealing with a factor can also be much more difficult than with a commercial bank. Banks are highly regulated, offer competitive rates and commoditized lending services, so entrepreneurs can, with few exceptions, easily anticipate the cost and terms of their loan. But factoring is very fragmented. Most factor financing is provided by smaller, unconventional lenders. It is much less regulated and the quality, reliability and integrity of factors vary widely.
The reason more startups are turning to this more expensive, risky alternative is simple: It is often the only way to get cash. And if it is the route you decide to pursue, due diligence is the single most important step. Investigate how long the factor has been in business, where its offices and headquarters are and the background of its management team. Ask for referrals from current clients, and research complaints or lawsuits using web searches, the Better Business Bureau and the state’s Attorney General’s Office. Also, trust your gut: If you feel you can’t build trust with the factor, don’t pursue the loan.
If you go forward, review your contract with a magnifying glass, particularly these points:
- What is the duration of the contract? The shorter the better–ideally, month to month. You want to switch to less expensive financing as soon as possible.
- Will the factor negotiate? Some factors allow contract negotiations while others offer only take-it-or-leave-it documents.
- Must you provide a personal guarantee? This allows the factor to go after you and your assets to be repaid. Some factors will lend without a personal guarantee or on a “non-recourse” basis.
- Will the factor take possession of your receivables if they are uncollected? Probably not, which means you’ll need to collect on your own. Be prepared: If receivables are uncollected, you’ll need to repay the factor’s advance or you may lose financing altogether.
- How will the factor notify your customers? Ideally, the factor will create a lockbox to accept payments in care of your company. You maintain day-to-day contact with your clients so that everything appears seamless and they are not aware of your financial situation.
- Will you be required to factor 100 per cent of your receivables? Cash flow and collections patterns fluctuate, and some weeks you may not need financing. If your factor requires you to finance all receivables, you will pay dearly for financing even when you don’t need it. Single-invoice or spot factoring allows you to opt out.
- Is there a minimum or maximum sales requirement? Some factors require a certain sales volume. If you are not within the limits, you may lose your financing–so the fewer restrictions, the better.
Finally, always keep the end in sight. The real goal with factoring is to improve your cash flow, increase liquidity and rebuild net worth to qualify for commercial bank financing. Commercial bankers can help you figure out the financial targets that can help you re-qualify, but it is up to you to create the plan.
As a commercial lender, I have seen businesses resort to factor financing for one or two years at the most. If the company still didn’t qualify for bank financing at that point, chances are, it was already out of business.
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