Advantages and Disadvantages of Factoring: From My Personal Experience
Over the past 25 years, I have built 6 companies in the $5 million to $25 million in revenue range with two of them making the INC 500 fastest-growing list. An outsider might think I self-financed all those companies, but the reality is that I used Factoring and business lines of credit to get me to the point where I could use existing cash flow to run my businesses.
Unlike most articles you will find about the advantages and disadvantages of Factoring, this article will be about true-life experiences in dealing with Factoring companies. There are some benefits and limitations in Factoring but one thing I got right early on was that I had a plan. I also knew the pro’s and cons of Factoring. Let me share with you what Factoring for businesses is really like and explain the advantages and disadvantages of Factoring.
What is Factoring
A definition of Factoring, sometimes misleadingly referred to as Invoice Factoring, is a form of financing used with businesses that are doing business with other businesses or government agencies. Factoring is not used in a business-to-consumer environment. The main reason for this is that Factoring is invoice financing and only in a B to B or B to G environment are their terms of 30, 60, or 90 days given.
In a Factor arrangement, a Factoring company will advance you money up to 70%-90% of a valid invoice. Providing that your client is creditworthy, and you have a contract in place with the Factor. So, in simple terms, if you have an invoice for $100,000 your Factor will give you 80% ($80,000) immediately. When your client pays the final $100,000 invoice, the Factor will keep his fees and send you whatever is left. As a business owner, you should understand the pros and cons of Factoring, and there are a lot more IMPORTANT details and advantages of factoring that we will discuss below but, in a nutshell, that is how Factoring works.
Recourse vs Nonrecourse Factoring
There are two types of Factoring, Recourse and Nonrecourse Factoring. Recourse Factoring is when your company will follow up to make sure your clients pay their invoices, and if your client does not pay the invoices, then you are responsible for the loss. Most Factoring companies are recourse Factors.
Nonrecourse Factoring is when your Factor is responsible for collections and if your client defaults then the Factor takes the loss. Nonrecourse Factoring is much more expensive and is used in situations where the Factor might be better at the evaluation of the creditworthiness of your clients such as in international sales.
Advantages and Disadvantages of Factoring
Factoring for Small Business is Easy
Many small business owners that have not applied for a line of credit, a business loan with a commercial bank or the small business administration (SBA) are surprised to learn how hard it is to qualify for loan. Banks and the SBA are the cheapest forms of business financing and because of that, they don’t like defaults. As a result, a bank will require all business applicants to have collateral, excellent personal and business credit, positive cash flow, and personal guarantees.
A Factor is much easier to qualify for because the Factor is not interested in your business’s cash flow or credit but in the creditworthiness of your client. As a result, many younger businesses will start working with a Factor until their business qualifies for a line of credit.
However, ever since the 2008 recession, new online business lenders have entered the market and are now making it much easier and cheaper for new businesses to qualify for an unsecured line of credit. In Fact, 80% of all small businesses use online lenders due to their faster application, lower approval requirements, and cheaper costs.
There are still some disadvantages of Factoring that we will touch on later. Factoring companies have been losing a lot of their business to online lenders due to the complexity of setting up a Factoring contract and its high costs.
Unlimited Financing: An Advantage of Disadvantage of Factoring?
One of the big advantages of Factoring is that your business will have unlimited business financing, and for me early in my business career, that was very attractive. Factoring allowed me to focus on driving revenue. I knew that my company could sell as much as we wanted and that I would have unlimited business financing, providing of course that the Factor approved of the credit of the companies we were working with.
My plan was that I would use the Factor until my business reached a point where I could go to another cheaper Factor which ended up happening after 18 months. In my case, that type of Factor was called an Asset Based Lender (ABL), which gave me a better deal. Eventually, after 12 months of being with the ABL, I was approved for a business line of credit with a local bank. From that point forward I never had to use a Factor again and due to these advantages of Factoring, I began to get to a point where I could reinvest my existing profits into the business and only use the credit line when needed.
No Yearly Renewals
Once you have a contract with a Factor, unlike with a bank line of credit, you will not have to submit yearly financials. With a Factor, you can continue to use the Factor as long as you want. That is both a good thing and a bad thing, as there will be some other disadvantages of Factoring that can come with this, which we will discuss later. However, with a bank, you will need to submit important financials yearly and you will often be concerned if you will be approved again.
I have always had an excellent credit score (750+), very good cash flow, timely financials, an excellent track record, and even excellent collateral and each year the banks I worked with would make me sweat.
Switching from one bank to another was always a big project and the banks have an approval process and costs in place that make it hard to make a change.
Commercial banks also were not always as cheap as they appeared due to application points and yearly maintenance fees required but compared to a Factor, a line of credit was always significantly cheaper.
The Advantage of Factoring is No Covenants
Commercial bank contracts for lines of credit are lengthy. As you begin to work with a bank you will learn more and more about the bank’s ability to pull your line if certain covenants are not adhered to.
Covenants are a contractual arrangement where a bank will require certain ratios to be in place in your business. If those ratios do not meet the bank’s minimums requirements, then a bank can pull or not renew your credit line. Banks don’t typically pull your line unless you miss a payment or two.
In my case, I never violated any covenants to cause my bank to cancel my credit line however I knew of businesses where the bank got nervous during a recession and audited the business, only to cancel the credit line because the bank got cold feet and used the covenants to close the line.
The covenants are an advantage of Factoring because Factors don’t really have them like commercial banks do.
60 Days to Get a Factor in Place
In general, it will take your business at least 60 days to work fully with a Factor, and this is an advantage of Factoring because that is significantly better than getting a bank line of credit. The biggest holdup of Factoring is that the Factor will need to get a contract with your client, ensuring that when an invoice is paid that the funds will come directly to the Factor.
Yes, that is right. Your business will lose control of checks coming directly to you. It will now go to a PO box that the Factor owns, and you will get paid your advances from the Factor.
I will talk about this more later, but this could be considered a disadvantage of Factoring, because the Factor may decide that some of your clients are not creditworthy and as a result, the Factor will not advance funds on those invoices.
Cons of Factoring or Disadvantages of Factoring
The Disadvantage of Factoring, It is Expensive
It is hard to determine the overall cost of a Factor because many variables will come into play. A Factor will charge your business for the length of time that an invoice is unpaid, they will charge some flat fees, and there will be a holdback reserve policy. The costs of a Factor will often be 19% to 60% APR while other Factors might even be higher.
Collections Assistance, Advantages and Disadvantage of Factoring
Keep in mind that in Recourse Factoring, you are still responsible for your accounts receivable, so you will want to try and get paid as soon as you can. A Factor gets paid more based on how long your invoices are outstanding, so yet another disadvantage of Factoring is that a Factor is not going to want to help you with collections.
However, I did find that my Factors were very experienced business people and that when asked, they were able to give me good business advice about how to improve my accounts receivable or how to adequately see if one of my new clients was creditworthy.
Client Notification and Permission
The biggest part of the Factoring finance process is the notification, approval, and permission of your clients agreeing to send their payments to a new location and a new name. Some of your clients might have a strict policy about allowing an invoice to be factored. Government agencies notoriously will not allow the Factoring of invoices.
This sometimes causes a problem because one of the top jobs of a small business owner is to make their business look bigger and more credible than it is. Your clients want to do business with financially stable companies. When it comes to Factoring for small business, once your clients hear that you are getting financing from a Factor they might be concerned about your viability, and that perception of you having a financially stable company might come into question.
I can honestly say that this was one of my biggest concerns and a real disadvantage of Factoring versus a line of credit. However, in my case, I was dealing with a lot of very big companies who had sophisticated finance departments that were used to invoices being Factored so I never had any problems with my clients agreeing to send their payments to a different location and a different company name.
I did have some government clients that refused to sign any assignment letters for invoices to be paid to a Factor so there are both advantages and disadvantages of factoring depending on who your clients are.
Holdback Policy is a Disadvantage of Factoring
Many Factors will require your business to keep a certain amount of money with the Factor on reserve. It reduces any risk that the Factor has regarding any fake invoices or disputes. This is a disadvantage of Factoring because by keeping that reserve you are unable to use those funds for your business nor earn any interest.
Challenges in Moving Away from a Factor
When I first used Factoring 20 years ago, I understood some of the advantages and disadvantages of Factoring, and I knew that they were expensive, so I planned to use them for a short period until I had enough good cash flow to keep getting better financing. I knew that better financing companies wanted to see more revenue, better profits, and good financials. After about 18 months with my Factor, my business was doing about $100,000 in revenue per month and I found another Factor (called an ABL-Asset Based Lender) that was half the price.
It took me and the new Factor about 6 months to move away from the old Factor due to getting new assignment letters, closing out existing invoices that still had not been paid, and getting the reserves that my Factor kept on file. Once I moved to the new Factor, I only used them for 12 months and by that time, I was doing about $300,000 per month in revenue and I qualified for my first line of credit with a bank.
Nowadays, with online business lines of credit like Financing Solutions, I would have gotten my business credit line in place a lot earlier and I could have even had the Factor and my Line of Credit at the same time.
Factors are Hard to Stop Using
Once you start using your Factor you will find that it is just easier to Factor all your invoices and, in some cases, your Factor will require it.
This disadvantage of Factoring is that it is expensive and because many business owners are so busy working in their business, you may not notice at the end of the year how much you just spent on Factor invoice financing.
Factoring Use in the Long Term
The only time a Factor or other financing should be needed is when a business is growing more than its profit margin. If your business is not growing that fast, then you should not need a Factor because your profits should cover your expenses. Unless of course your collections are being paid in 90+ days instead of the normal 45 days or less.
However, many businesses use Factoring for a very long time because their business is simply not charging enough for their services or products. Not charging enough is one of the number one biggest problems small businesses consistently have. If you are using your Factor for a long time, you might see the problem that your gross profit margins are too low.
In my case, my business had very good profit margins and for the first 5 years, our growth was like the traditional hockey stick that everyone talks about. At about the 5-year mark, our growth reached its peak and our revenue stayed flat. It did not take me long to realize that the only time a business needs financing is when it is growing.
Problem clients Not Paying
Factors will have terms relating to how long they are willing to wait before you will be required to pay the Factor back. For example, if the Factor advances you $10,000 and your client has not paid the invoice in the specified time, the Factor will require you to pay them the advance that they gave you back. So bad debt and slow-paying clients are still your problem and this can be a key disadvantage of Factoring.
Trustworthy Factoring Companies
I believe I got lucky with the Factoring company I first used 20 years ago. They were a new company, and I was their first client so although they were expensive (I did not know that at that time), I always felt they were good people.
Another disadvantage of Factoring is that the contracts are complicated and there are a lot of details that you must understand. Once I moved to the second Factoring company, I made sure that my accountant and lawyer read the Factoring contract, so I understood all the terms, conditions, and fees.
The second Factor I used was a huge company and therefore, their contract was lengthy and hard to understand. I am not always the most detailed guy and at that time, I was known to just plow ahead and worry about the consequences after.
It is important that you spend the time understanding if the Factoring company you will be working with is credible and that you understand exactly how the fees will be charged. You must work with a credible company to garner the full advantages of Factoring. Although I got lucky with the Factoring companies I worked with, it is always advisable that you know what and who you are detailing with.
There are two well-known Factoring associations. The International Factoring Associations and the American Factoring Association contain some good information about the advantages and disadvantages of Factoring. I learned about these associations much later in my career after I considered starting a Factoring company myself instead of the business line of credit company I own now, Financing Solutions.
The IFA and AFA are good organizations that help Factoring companies however the association does have a code of conduct that helps businesses ensure you are dealing with a professional factoring company. If you are looking for a Factoring company those associations might be a good place to start.
Alternatives to Factoring and Banks
In 2008 a major recession hit the United States due to banks giving out too many loans to unqualified borrowers. The country came close to a depression which means over 15% of the public is out of work. At that time, and with many recessions in the past, banks stopped lending regardless of how good your business was doing. During a recession, there are still businesses that are growing and very profitable.
However, this time when the banks stopped lending a new group of private online lending companies stepped in. Due to the ability of the internet and new technology to evaluate creditworthiness quickly and differently, for the first time, a small business line of credit or business term loan could be offered cheaper and faster to small businesses.
Financing Solutions Business Line of Credit Product
Around that time Financing Solutions began to offer small businesses and nonprofits a line of credit that was better than a commercial bank. For example, the Financing Solutions Line of Credit costs nothing to set up, nothing until used and when used, and is cheaper than a bank or Factor. This credit line was born out of the idea that most small businesses only need a cash back-up plan for emergencies and opportunities.
Unlike a bank or a Factor, the Financing Solutions line of credit application only takes 2 minutes to fill out and the approval process is based on personal credit score, cash flow, and your industry. Because of our experience, our underwriters have a clear understanding of what your business can afford as far as the approved amount for a credit line.
Financing Solutions is a direct lender that is A+ certified by the Better Business Bureau and is 5 stars reviewed.
Please click here to apply for a no-obligation, no credit check business line of credit.