Factoring Is an Often-Overlooked Liquidity Source for Distressed Companies
By Chris Lehnes, Factoring Specialist
Turnaround professionals are often tasked with helping their clients obtain the capital needed to navigate the restructuring process. To meet this challenge, it is essential to understand the wide variety of commercial financing options available.
The commercial lending industry is still adjusting to the impact of COVID-19. This includes the liquidity which flooded the market from U.S. government programs such as the Payroll Protection Program (PPP) and Economic Injury Disaster Loans (EIDL) administered by the Small Business Administration (SBA). In addition, the temporary loosening of regulatory restrictions enabled banks to hold onto loans that otherwise would have been moved into workout. Factoring Is an Often-Overlooked Liquidity Source for Distressed Companies.
Now, more than 24 months since the first lockdowns, much of that liquidity has been used up, and banks are starting to reevaluate their loan holdings and take necessary steps to protect their portfolio performance. Many businesses in turnaround will require an alternative source of financing until they are rehabilitated and can qualify for more traditional financing. Factoring Is an Often-Overlooked Liquidity Source for Distressed Companies.
One financing option that is often overlooked is factoring, which involves the sale of a company’s accounts receivable to obtain working capital. Many factors focus more on the quality of a company’s accounts receivable than on its financial performance, which can make factoring an option for a business in turnaround that has a strong customer base but whose financials are not strong enough for the company to qualify for traditional commercial loans.
Factoring provides liquidity for businesses that cannot afford to wait 30 to 90 days for their customers to make payments on their invoices. It can provide a source of funding for businesses whose applications have been declined by a traditional lender because the business:
- Is a start-up or otherwise has insufficient operating history
- Is fast-growing and needs more credit than a lender is comfortable extending based on the company’s history
- Is seasonal with erratic revenue
- Has historic, current, or projected losses
Most factors put few restrictions on how funds may be used, but uses can include financing for bridge loans, projects, business growth or acquisition, working capital needs, crisis management, and DIP funding, among others. Factoring Is an Often-Overlooked Liquidity Source for Distressed Companies.
To be eligible for factoring, a client must be a business-to-business (B2B) or business-to-government (B2G) business with a strong customer base 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 concerns.
Most traditional factors exclude construction and third-party medical accounts receivable (insurance company, Medicare, Medicaid), but some specialists focus on these niches.
Terminology
A true factoring facility is not a loan, so turnaround professionals should familiarize themselves with some of the basic factoring language, which differs from lending (Figure 1).
There are a variety of ways in which a factoring facility can be structured. While this article does not attempt to describe every nuance of factoring, there are a couple of key differences of which every turnaround professional should be aware. These are recourse versus nonrecourse and notification versus non-notification.
Recourse vs. Non-Recourse. In recourse factoring, if a client’s customer is unable to pay an invoice or does not pay within a specified amount of time, usually 60 or 90 days, the client is responsible and must repay the advance received for that invoice. In non-recourse factoring, the factor assumes the risk of nonpayment by the customer, 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 the client’s business as well as that of their customers, while nonrecourse 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. As a result, a non-recourse factor is generally able to meet the needs of businesses in weaker financial condition, including those undergoing a turnaround or bankruptcy restructuring, and a recourse factor may charge a lower fee.
Notification vs. Non-Notification. A notification factor contacts the accounts payable (AP) departments of a client’s customers and instructs 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 the need arises.
With non-notification, the factor may use a lockbox so that checks can be made payable to the client but to an account the factor controls. Non-notification factors may have little or no contact with the client’s customers.
Due to the greater control over the flow of cash, a notification structure can generally accommodate businesses in weaker financial condition and is often a better fit for a business in turnaround.
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 will likely 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 90% against AR, with factoring fees ranging from 1% to 3% of the invoice for each month the invoice is outstanding. The time may be broken down into 5-, 10-, or 15-day increments. Some factors charge both a factoring fee and an interest rate charge for the funds advanced, so clients should make sure they understand all fees they may incur. Lower rates typically are tied to recourse factoring with its greater focus on business performance
The term of a facility can range 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 as long as the client continues to sell to creditworthy entities. Many factors require their clients to commit to a specified 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 PPP and EIDL loans, but obtaining such approval can take time.
Initial funding under a factoring facility often occurs in less than a week. Once a facility is in place, funding usually takes place 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 verified, the factor advances the client its funds. 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 10% t0 25% of the invoice, minus the factoring fee.
Choosing a Factor
Reputation and industry expertise matter 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 may not be the best suited for a staffing agency.
Understanding a factor’s notification and verification process is important, particularly how the firm will interact with the client’s customers. It’s 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 if markets deteriorate?
Turnaround practitioners may find that factoring will remain essential funding sources for their clients for years to come. To learn more, contact Chris Lehnes at 203-664-1535, clehnes@chrislehnes.com Connect on LinkedIn