Factoring your receivables enables you to get the cash you need immediately to operate your business, without waiting a month or even longer, for your customers and other creditors to pay down their invoices.
When entering into a factoring arrangement, as with any contractual relationship, it is important to understand the issues and requirements that are in the contract before you sign it. Unless you are clear about it, some of the issues can be problematic. Here we will discuss some of the key issues that you should consider before signing a factoring agreement.
Understand the Factor’s Fee Structure
The biggest issue is the fees you will be paying for the factoring service. Factoring fees vary so it is important to know not only what the fees are but what you are getting for them. Most factors charge a percentage of the amount of the invoice they are factoring. You need to know the discount rate, advance rate, and any other setup fees that are involved. Factors do not use your credit history when they determine whether or not to work with you. However, they do look at how creditworthy you are and your total accounts receivable in determining your fees.
Be on the look out for factoring firms that offer low introductory rates or fees that are below the industry as a whole. You should find out if there any additional fees or requirements that could go into effect after the start of the contract.
If you sign a contract that requires a specified minimum amount of activity, be sure that you have enough business and you generate sufficient invoices to fulfill that minimum.
The Term of the Contract
A critical component of the factoring agreement is the term of the contract. If you are new to factoring or looking for a new factoring firm, you might wish to limit the length of the contract. If you do not know the factor, a long-term contract may be detrimental if it turns out that the relationship is not the right one for you. You should keep your options open, so you do not get locked into a long-term contract with the wrong factor.
Another important issue in factoring is collateral. The creditworthiness of your customers is the factor’s decision on whether to work with you, and their fees and advance rates. Collateral might be required in some cases such as if you are requesting higher advance rate or would like help with trade finance.
Collateral might be required if the credit history of one of your customer’s is poor, but you still want to factor the invoice. In this case, you might be required to put up some collateral to guarantee repayment of the advance in case the customer does not pay. Some types of collateral that might be required might include a direct pledge of a stock portfolio or real estate.
Recourse or Non-Recourse
Your contract should say whether the factoring is being done on a non-recourse or recourse basis. If you want the factor to provide credit protection for your receivables in case the customer does not pay, then you will specify the factoring be done on a non-recourse basis. There might be extra fees, but it will be worth it to relieve you of the collection problems.
Have an Attorney Review the Contract
It is a good idea to have an attorney review your contract since they are experienced with financial firms. They might be able to spot some problems that you may or may not have considered. For example, there might be hidden fees that you did not see initially. Or he can help you decide if you need value-added services that would add to the overall cost of the factoring or not.
The Bottom Line
Factoring is an important service that can help you meet the working capital needs you have and other financial obligations. When contracting with a factoring firm, it is important that you and your attorney understand all of the issues involved to assure financial well-being of your firm.