Consider a small staffing company that provides 10 security guards to a local branch of a large national retailer. Each week, the staffing company (“supplier”) invoices the retailer with Net 30 Day terms, and receives payment about 45 days later. This is quite common, as the retailer will retain a good credit rating with this type of payment history. The supplier makes payroll each week with payments received that week from invoicing that was done 45 days earlier.
Finally, the staffing company receives the break-through that they’ve been working on for some time: the retailer offers the opportunity to provide them with 30 security guards, working at other branches. The obvious challenge, however, is how to make the newly increased payroll each week, when the first of the larger payments will not arrive for 45 days after the first, larger payroll is due.
One option is to apply for a loan or line of credit at the bank. To qualify requires strong financial statements for a couple of years. This is rarely possible for a new company. Furthermore, the current banking environment makes it harder than ever to qualify. If the applicant company does not have real assets to use as collateral (e.g. property), obtaining a loan may not be a viable.
The staffing company, however, does have one valuable financial asset: its Accounts Receivable (i.e. its invoices) of the money owed to them by the retailer. The real value is that the Receivables are matched by the Accounts Payable of a financially solid customer with a good credit rating. There is a type of business lender that will make advances on these Receivables: a factoring company (a “Factor”.) Factoring is also referred to as “Receivables Financing”, “Invoice Funding” and other variations on this theme.
A Factor will buy invoices that have already been billed to the customer, and can continue to buy new invoices as the factoring client produces them (i.e. once a service or product has been delivered according to the contract or Purchase Order.) This allows the staffing company to get the funds it needs each week to meet its increased payroll.
The Mechanics of Factoring
Once a supplier company has delivered its product or service, and typically has documentation that this has been done (e.g. signed time cards, delivery receipts, etc.) it creates an invoice and provides this billing paperwork to its Factor. The Factor then immediately provides a funding
that is called an “Advance”, usually around 80%-90% of invoice amount, to the supplier. The difference between the Invoice Amount and the Advance is called the “Reserve”. The Factor then bills the customer with the supplier’s paperwork, but the Remit-To address is changed to a bank lock-box that is under the control of the Factor.
Once the Factor receives payment from the owing customer, it calculates its fee, which usually depends on the time it takes to receive payment and the dollar amount that the supplier factors each month. For a common payment time of 45 days, the fee can be anywhere from 2% to 4%. This fee is deducted from the Reserve amount, and the remaining Reserve is made available to the supplier. How quickly the remaining Reserve is accessible to the supplier is one of many details that differ among the various Factor companies.
Requirements
It has been mentioned earlier that the paying customer must be a firm that has decent business credit. The Factor makes this determination, often using tools such as credit reports from business credit reporting agencies (e.g. Experian, and Dunn & Bradstreet).
Once it is comfortable that the customer can be depended upon to pay the invoices, the Factor’s next concern is whether these payments will reach the Factor. The greatest threat to payments reaching the Factor is the existence of a lien on the supplier’s Receivables and other assets. Sources of liens can be from other lenders (equipment financiers, banks), a court judgment due to a legal suit, and, worst of all, a tax lien. During the application process, the Factor will collect documents from the supplier, such as Articles of Organization, company tax returns, and ownership papers, in order to be able to perform a thorough lien discovery search.
Epilogue
Some supplier companies only need to factor for a limited amount of time, until their incoming payments reach a steady-state with their out-going obligations. Others find factoring to be an on-going need, especially in certain industries such as trucking and staffing. Still others manage to use factoring to create good credit ratings for themselves, by making fast payments to their own suppliers. In these cases, they are eventually able to qualify for a bank line of credit that is large enough to fully finance their cash flow needs. While banks do not provide the other factoring services of credit checks, billing, and collection, the cost of the money is less expensive. A supplier company that has a billing/payment history with a stable core of customers may well be able to perform these services for itself.
Peter Crotty
Business Development Officer, Interstate Capital Corp (ICC)
Toll Free: 800-948-8638
Fax: 909-354-3320
pcrotty@interstatecapital.com
www.interstatecapital.com
Tags: Funding for small business
I didn’t all that. That’s a lot of helpful information. Thanks for taking your time to write this.