Factoring: Cash for a Healthy Supply Chain – Convert Invoices to Cash

By Chris Lehnes, Factoring Specialist

The success of nearly every business is dependent on its supply chain.  Whether a neighborhood restaurant securing fresh produce from a local farmers market in time for tonight’s menu or a high-tech manufacturer which procures microchips from Asia ordered months in advance, a business will quickly fail if it is unable to reliably obtain the components of their product in time to meet their customers’ expectations.

There are myriad conditions which can disrupt that supply chain. Some of which can be as isolated as local traffic delaying a delivery truck on the last mile of its journey or as far-reaching as a natural disaster which can close ports or destroy the facility of key supplier causing a disruption which may require a business owner to rethink how it acquires its inventory going forward.

Over time, to reduce costs and increase efficiency, the links in many supply chains have become increasingly specialized.  This customization has resulted in their rigidity. A supplier of one specific component can often not readily adapt to supply others. During the (hopefully) once-in-a-generation supply chain disruptions brought on the COVID-19 pandemic, many were surprised to learn that the factory which produces toilet paper for sale to commercial property managers cannot easily adapt and package their product for consumers, or the meatpacking plant which can cut and package chicken for bulk sale to restaurants has no simple way to prepare that same poultry for sale to supermarket shoppers.

This inflexibility can at times result in a business having fewer options to fill an unexpected gap in their supply chain, putting suppliers in a powerful position to place, at times, onerous demands on their customers.

Those demands can severely disrupt a business. Knowing substitutions for their product are limited, suppliers may prioritize their top customers, making it harder for smaller customers to procure necessary components. In other cases, suppliers may require large deposits with orders or refuse to offer payment terms at all to customers, insisting upon payment up-front with a purchase order. These payment conditions will create a demand for cash earlier in a company’s production cycle.

This demand can be met in a few ways.  If the business is highly profitable, it may generate sufficient cash from operations to satisfy this cash needs.  In other cases, a business will have access to a line of credit from their bank or an asset-based credit facility from a non-bank lender to meet these cash needs as they arise.

However, most readers of this publication tend to have clients who are not flush with cash or those which may have a lender in place today who is no longer comfortable with the performance of the business and is reducing the size of their credit facility or pressuring them to find a funding alternative. For those clients, factoring may be their best option to meet the cash flow challenges presented by their supply chain.

Factoring is a funding option with which every turnaround and restructuring professional should become familiar.  Factoring involves the sale of a company’s accounts receivable to obtain working capital. Many factors focus more on the quality of AR than on financial performance, which can make factoring an option for a business that has a strong customer base but whose financials are not strong enough for the company to qualify for traditional commercial financing. 

Many factors are not concerned with the lending criteria which would cause a business to be declined by a bank.  For example, many factors will fund a new business, or one which is fast-growing and needs more credit than a traditional lender would allow based on its operating history. In addition, while most traditional lenders are hesitant to fund seasonal businesses or those with historic or projected losses, many factors target this client profile.

There is often no restriction on how factoring proceeds are used and they are often put to work as a bridge or for short-term project financing.  However, it is common for a business to use their factoring facility in much the same way a line of credit would be used: to meet the daily cash obligations of the business. This can be key when a company’s supply chain requires more cash earlier in the production cycle.

Not every business is eligible for factoring. Your client must be a business-to-business (B2B) with a strong customer base or business-to-government (B2G) business and annual revenues of from $100,000 to $100 million. The business must bill for a delivered product or completed service, as opposed to collecting deposits or performing progress/milestone billings. Common factoring clients include manufacturers, food producers, distributors, wholesalers, and service businesses, such as staffing or trucking companies.

There are a variety of ways in which a factoring facility can be structure and there are a couple of key differences of which turnaround professionals should be aware, namely recourse versus non-recourse and notification versus non-notification.

Recourse vs. Non-Recourse

With recourse factoring, if one of your client’s customers is unable to pay an invoice or does not pay in a specified amount of time  – usually 60 or 90 days – the client is responsible and must repay the advance received. Under non-recourse, the factor takes on the customer’s credit risk  – that they are unable to pay – but the client remains responsible for most other discounts or deductions their customer may take on an invoice.

A recourse factor will often underwrite both the credit of your client’s business as well as that of their customers while non-recourse factors are usually more focused on the quality of the accounts receivable and put less – or in some cases, no – emphasis on the financial performance of the business.

The result of this difference is that a non-recourse factor is generally able to meet the needs of businesses in a weaker financial condition  and a recourse factor may carry a lower price.

Notification vs. Non-Notification:

A notification factor will contact the AP department of each of your clients’ customers and instruct them to make payments to the factoring company.  Each invoice issued will usually include instructions that payments must be made payable to the factor.  The factor will also usually make collection calls to the customers if necessary.

With non-notification, the factor may use a lockbox so that checks can be made payable to your client, but to an account the factor can control.  Non-notification factors may have little to no contact with the client’s customers.

Due to the greater control over the flow of cash afforded by notification, this structure can accommodate businesses in a weaker financial.

Approval and Funding

For a non-recourse factor, little information other than a recent accounts receivable aging report and customer list may be necessary to obtain a proposal, which the factor will use to assess the quality of the customer base. Recourse factors perform more of a hybrid analysis and usually require a standard commercial financing package, including current and historic financials, so they can underwrite the business performance as well as the accounts receivable. Term sheets may be issued in as little as a few hours up to a few days.

Terms of factoring facilities vary but usually consist of an initial advance of 75% to 95% against AR, with factoring fees ranging from 1% to 3% of the invoice for each month the invoice is outstanding. The fees may increase in 5, 10, or 15-day increments. Some factors charge both a factoring fee and an interest rate for the funds advanced, so clients should make sure they understand all fees they will incur. Lower rates typically are tied to recourse factoring with its greater focus on business performance.

The term of a facility ranges from 0 to 24 months, and factoring volume can range from $10,000 to $10 million or more per month, with different factors focusing on the low and high ends of the range. Some factors set no cap on their facility and will allow fundings to grow as the client’s business grows if the client continues to sell to creditworthy entities. Many factors require their clients to commit to a minimum factoring volume each month.

Factors usually require a first lien on AR, so turnaround practitioners should ask their client early in the process whether they have any outstanding liens on their AR. An incumbent lender may be willing to subordinate its lien to allow factoring, but that is rare. The SBA usually will agree to subordinate EIDL loans, but obtaining such approval can take time.  Getting a subordination on an SBA 7(a) loan can be unpredictable.

Initial funding under a factoring facility often occurs in less than a week. Once a facility is in place, funding can take place as soon as the same day a new invoice is issued. The client does business as it always has, shipping products or completing services and then invoicing the customer. The invoice is also sent to the factor. For a notification factoring facility, the invoice includes instructions for making payments to the factoring firm. The factor verifies the invoice by contacting the customer’s AP department. When the invoice is confirmed, the factor advances funds to the client. Most factors will fund their clients as often as daily, or less frequently as needed by the client.

After the factor receives payment from the customer, the client receives the “rebate,” the remaining 5% to 25% of the invoice, minus the factoring fee.

Selecting a Factor

Reputation and industry expertise are important when choosing a factor, so it’s a good idea to request references and seek recommendations from one’s network. The right factor for a manufacturer of high-tech equipment may not be the best suited for a commercial bakery.

Understanding a factor’s notification and verification process is important, particularly how the firm will interact with the client’s customers. It is also wise to ask about a factor’s funding source. Many rely on lenders or other factors for their funding. Will those sources remain available throughout the economic cycle?

By helping fund your clients’ immediate supply chain needs, factoring may become a vital source of working capital for years to come. Chris Lehnes is a business development officer representing Versant Funding, a non-recourse factor targeting tough-to-finance businesses needing from $100,000 to $10 Million per month in funding.  He has over 30 years of commercial finance experience.  Before moving into asset-based lending and factoring, he spent nearly 15 years with one of the country’s top SBA lenders holding a variety of leadership positions in closing, underwriting, operations management, marketing, and business development. 

Chris Lehnes can be reached at clehnes@chrislehnes.com or 203-664-1535. Connect on LinkedIn

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Factoring: An alternative source of financing during a crisis

By Chris Lehnes, Factoring Specialist

A primer for commercial finance brokers

• A challenge each commercial loan broker faces is understanding the options available to their clients.
• As the commercial lending markets enter unprecedented conditions, these options are changing and the onus is on the broker to stay informed.
• You have all see seen that the COVID-19 pandemic has caused many commercial lenders to tighten their lending standards or put an outright freeze on new loans as they assess its impact
• The initial funding allocated to Small Businesses under the CARES Act have been exhausted
• While some businesses may be able to wait for the next round of government funds, B2B businesses with strong customer bases have an alternative: Accounts Receivable Factoring
• Factoring Definition: Sale of a company’s accounts receivable  in order to obtain working capital
• Types of factoring include recourse/non-recourse, full notification/non-notification
• With recourse, if a customer is unable to pay, the client is responsible. Under non-recourse, the factor takes on the customer’s credit risk
• Some will underwrite both the business and the quality of the accounts receivable (resource)
• Non-recourse factors are usually more focused on the receivables and put less (to no) weight on the performance of the business
• Your client must be a B2B business with a strong customer base to qualify
  • Manufacturers, food producers, distributors, wholesalers, service business – staffing, trucking
  • Most factors exclude construction & third-party medical accounts receivable (insurance company, Medicare, Medicaid) but there are specialists which are focused on these niches
• Focus of this piece will be on full-notification, non-recourse factoring which is best positioned for today’s credit environment.
• Typical terms:
  • Usually consists of an initial advance of 75 – 90% against accounts receivable
  • Factoring fees range from 1 – 3% of the invoice for each month the invoice is outstanding
  • Lower rates are typically reserved for recourse factors with a greater focus on business performance
  • Some factors charge both a factoring fee (aka discount) as well as an interest rate on funds advanced
  • Be careful to “read the fine print” as there may be other charges from many factors
  • Term: 6-24 months
  • Size: $10k – $10 Million+ per month in factoring volume
    • Different factors are focused on the low and high end of this range.
  • Some factors set no cap on their facility and will allow fundings to grow as the client’s business grows as long as they keep selling to creditworthy companies
  • 1^St lien on AR will be required – Ask your client early in the process if they have any outstanding liens on their AR
• The approval process:
  • For a non-recourse factor, little information over and above a recent Account Receivable Aging and Customer list should be necessary to obtain a proposal.
  • Factors which perform more of a hybrid analysis may also require a standard commercial financing package including current and historic financials.
• The funding process:
  • Can differ from factor-to-factor
  • Your client does what they do…ship products, complete services, invoice customer
    • Factoring is very different from PO financing.
      • With Factoring the goods must be delivered or service completed.
  • Notification: Invoice will include payment instructions to factoring company
  • Invoice is sent to factor
  • They will verify the invoice by contacting the customer (also known as the account debtor)
  • Upon verification, they advance your client 75 – 90% of the invoice – often the same day the invoice is issues
  • When the factor receives payment from the customer, your client will be sent the “rebate” The remaining 10  – 25% less the factoring fee.
  • Most factors will fund their clients as often as daily, or less frequently as needed by the client
  • If an invoices goes over 90 days
• Client Profile:
  • Small to mid-sized B2B companies with annual revenues from $100k to $100 Million
  • Businesses which need liquidity and can’t afford to wait 30-90 days for their customers to  make payment
  • Declined by traditional lender for reasons such as:
    • Start-up/Insufficient operating history
    • Fast-growing – needs more credit than a lender is comfortable extending based upon the history of the company
    • Seasonal businesses – erratic revenue
    • Companies with historic, current or projected losses
  • Client’s customers are large corporations, municipalities or other government agencies
• Use of factoring proceeds:

Most factors put no restrictions on how funds may be used, but can include:

• Project Financing
• Business Growth Financing
• Business Acquisition Financing
• Bridge Financing
• Financing Working Capital Needs
• Realization of Supplier Discounts
• Preparation for High Season
• Crisis Management
• Debtor-In-Possession (DIP) Financing

• Choosing your factor:
  • Reputation matters
    • Google the company
    • Ask about their funding source
      • Many rely on lenders or other factors for funding
        • Will those funding sources continue to fund their business if markets continue to deteriorate?
    • Ask about industry expertise
    •  
      • The right factor for your manufacturer client may not be the best suited for your staffing client.
    • Ask for references
  • To learn if your client could benefit from factoring, contact Chris Lehnes at 203-664-1535 or clehnes@chrislehnes.com Connect on LinkedIn
  • Request a Proposal