Before answering the question “What are factoring companies?”, it is first important to understand the concept of factoring itself. Without fully comprehending what constitutes factoring, it would be difficult to describe what a factoring company is, how it works, and how to choose one. Factoring can easily be defined in one simple sentence: “A financial transaction whereby a business sells its accounts receivable (i.e. invoices) to a third party (called a factor) at a discount.”
What is Factoring?
Many people have never heard of factoring, but those who have may not truly understand what it is. A common misconception about factoring is that it is something that both small and large businesses use as a last resort type of financing when traditional types of bank financing options are not available. In reality, however, businesses of all sizes and in almost all industries across the world utilize factoring. They do so because factoring invoices can help accelerate a business’s cash flow.
In almost every type of business in which invoices are to be paid by debtors for goods or services, there is a lag time between when invoices are issued and when debtors remit the money that is due. In a perfect world, debtors would pay invoices immediately in every circumstance. In reality, however, it can take weeks or months for invoices to be paid by debtors. Depending on the specific situation, this waiting period can cause financial stress on a business. In order to alleviate this non-perfect cash flow circumstance, businesses may decide to sell their invoices to factoring companies.
When invoices are factored, it means they are sold at a discount to a factoring company. The factoring company often pays a lump sum for the invoices, although the exact terms of the agreement between the business and the factoring company are usually unique. The factoring company then collects the amount due from the debtors. In most cases, factoring companies are paid by debtors directly in as little as a few weeks, and sometimes up to a few months after the invoices are due. Experienced factoring companies know which types of invoices are good risks and typically they avoid purchasing invoices they do not think are collectable.
What is a Factoring Company?
A factoring company is the organization that purchases invoices from businesses that want quick cash flow. Factoring companies work to collect on each individual invoice that was sold to them. The process for getting this accomplished can involve several steps.. Each factoring company uses its own business model, but most factoring companies follow a relatively similar process.
In most cases, a factoring company must work very closely with its business clients to ensure the process is smooth and that debtors understand that their invoices have been sold to a third party (i.e., the factoring company). Factoring companies do not always accept all invoices that are up for sale. Prior to making an agreement with its business clients, the factoring company must carefully review the invoices up for sale by the business. In most cases, once the factoring company approves a batch of invoices, the business sends a notice to its debtors alerting them of the situation and telling them where and how to remit their amount due.
Once notices have been mailed to debtors, both the factoring company and its business clients must keep careful track of which invoices have been paid and which remain out-standing. In situations where invoices are substantially past-due or never paid, the factoring company and its business clients must rely on their pre-arranged agreement on how such situations are handled.
Parts of an Agreement with a Factoring Company
Not surprisingly, agreements between factoring companies and their business clients range from relatively basic to complex. Because every business entity is unique, potential legal issues as well as possible problematic scenarios must be contemplated prior to agreements being signed. While there are dozens of points that must be evaluated as part of the agreements between businesses and factoring companies, the following are three especially important aspects of the agreements:
First, one of the most important aspects of the agreements between factoring companies and their business clients is the sale and purchase price of the debtor’s invoices. Because there are many factoring companies in business around the world, this piece of the agreement is often highly competitive and sometimes slightly negotiable.
Second, it is extremely important to negotiate the timing of any reserve payments from factoring companies to their business clients. Some factoring companies hold reserve payments longer than others, so this is a point that must be negotiated and agreeable to both parties.
Third, it must be determined whether or not factoring companies have the right to reject certain debtor invoices and only purchase the invoices that look favorable. In some cases a business will only want to factor some of its invoices and not all. Both of these scenarios should be addressed in the agreement.
How to Choose a Factoring Company
Understanding the question, “What is a factoring company?” requires the comprehension of many complex financial scenarios. However, once a general command of factoring has been grasped, the next step is determining how to choose a specific factoring company. In addition to evaluating whether or not prospective factoring companies work with businesses of varying sizes, there are several other details that should be considered.
It is important to assess the reputation of the factoring company. Is the factoring company known for any misconduct? Have other clients made negative statements or complaints about the factoring company? Or, are there glowing reviews from current and/or past business clients about the factoring company?
How much is the factoring company going to charge? While factoring companies are generally competitive in their pricing, there can be a significant difference between one company and another. It is important to get quotes from a few factoring companies and determine which has the best fee structure and payout schedule.
What is the factoring company’s level of experience? Factoring companies that have been in business for decades and are well-known in the factoring industry are often safer bets than brand new factoring companies that are just breaking into the business. While this not necessarily true in every single case, it generally takes many years to fine-tune a factoring business so that it runs efficiently and successfully.
Level of customer service. No matter how lucrative factoring seems to be, there is nothing worse than working with a factoring company that provides less than excellent customer service. It is important to keep in mind that poor customer service at the very beginning of a business relationship with a factoring company does not bode well for businesses in the long run.
Editor’s Note: Greg Curtiss is President of The Invoice Bankers. Mr.Curtiss is a lawyer and has passed the CPA exam. He has been in business for over 25 years. You can reach him by calling 303-740-7600 or 1-888-740-1750.