Sadie Keljikian, Express Trade Capital
There are numerous varieties of business financing, some of which are better understood than others. Everyone’s heard of commercial bank loans and most people are familiar with popular debt financing methods like credit cards and mortgages, but less well known financing vehicles like factoring receivables are often met with either blank stares or immediate suspicion.
At its core, factoring is a simple process. When a wholesaler sells goods on open terms, a financial institution can buy the right to collect from the customer, which is called a receivable, at a discount (to account for factoring fees). The original holder of the receivable gets their money immediately and the financial institution (usually called a “factor”) collects their fees from the debtor’s payment.
Although the process of factoring is straightforward, as in any industry, some lenders will take advantage of less savvy clients with confusing language and hidden charges in their contracts, which have given factors a justifiably bad name. Over the years, the industry’s ethical practices and common standards have evolved and reduced the dodgiest lending practices, though some still persist among less scrupulous lenders.
Here’s a few reasons why the stigma associated with factoring has persisted and how to avoid the tricks:
Opaque Sales Practices
One of the most common ways in which less reputable factors take advantage of their clients is to simply avoid explaining the details of the arrangement. Although the basic factoring process is simple and the upfront costs are usually easy to understand, small, recurring charges can add up to substantial costs of which the client may be unaware until it’s too late.
If you’re signing on with a factor, don’t be afraid to ask them to walk you through exactly how much they will charge you, when, and why. If your factor is trustworthy, they will have no problem holding your hand and explaining how the process works and what fees and interest you will accrue.
Here are some of the most common terms that salespeople might leave out in an attempt to paint a rosy picture and omit the gritty (but important) details:
- Annual minimums
- Monthly minimums
- Per-invoice minimums
- Termination fees
- Misdirected payment fees
- Substantial default provisions
Impact on Customer Relationships
One of the benefits (or sometimes drawbacks) of signing on with a traditional factor is that they will take over your collections process for all factored invoices. Outsourcing collections can certainly free up your time and even speed up the process when you employ a good factor. However, not all collections departments are equal and things can get ugly if the factor’s collections department is brusque or unprofessional, thereby straining the buyer-seller relationship.
Too many wholesalers avoid discussing the collections process with their customers. Though it may feel unpleasant, hashing out payment details is crucial to the professional relationship. A proper factoring collections department must be personable and know how to express urgency to collect payment without insulting, annoying, or harassing the customer. To get a sense of whether a potential factor conducts collections well, ask them about their methods and whether they consistently collect from larger debtors. Chances are, if a factor has been around for a while and they consistently deal with larger accounts, they have likely figured out the basics of collections.
MYTH DEBUNKED: Only Struggling Businesses Use Factoring
Some circles hold generalized stigma against businesses that choose to factor their receivables. Since many businesses who choose to factor their receivables can’t get the financing they need from a bank, some people hold an outdated notion that factoring is a business’s death rattle. However, this is a misconception driven by misunderstanding of how banks make lending decisions.
Banks are notoriously risk-averse and typically have extensive requirements and burdensome regulations for businesses that wish to secure financing. Since the money banks lend comes from deposits, legal regulations limit bank loan approvals to only the safest transactions. As a result, businesses that bankers often reject as “high-risk” are usually not failing at all. On the contrary, many businesses grow too fast for bank lines to keep apace. Others might have cash flow gaps that banks are simply unable to fill due to the limits of their charter, internal lending formulas, or balance sheet requirements. Still other businesses are simply too new to qualify or are not bankable for otherwise unimportant reasons that put them outside the bank’s comfort zone.
As mentioned above, most businesses who utilize factoring lines are in no way failing. Many businesses actually factor their receivables because they are growing faster than their current cash flow and/or bank lines can accommodate. In such cases, businesses must supplement their cash flow with financing to ensure that they have enough capital to meet overhead and fulfill their customers’ orders. In such situations, factors and their counterparts (purchase order funders, and other asset based lenders), can offer ideal solutions.
Most of the stigma of factoring receivables comes from misunderstanding, a few shady factors, and the persistence of archaic notions. A few bad apples do not spoil the bunch, but rather should encourage businesses to educate themselves on good lending practices and seek out a reputable financier. If you have an opportunity to ramp up your sales volume and grow your business, factoring your receivables is often the most effective solution. If operational funds are tight and the orders keep coming in, don’t fret. Find potential providers, ask the right questions, trust your gut, and make the move.
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