For small firms, credit and collections can now be done the old-fashioned way - by factoring.
Long since a staple of the garment industry in New York, the Carolinas, and Los Angeles, factoring is now widely available to commercial firms of just about any size in just about any industry. This new breed of factor differs greatly from the traditional counterpart. It is these differences that must be understood by today's credit managers if factoring is going to find a home within the small business community, the way it has with the apparel, textile, carpet and furniture industries. To appreciate how the small-business factors differ from the traditional factors, we must first examine the tradition.
The History of Factoring
The word "factor" means "to facilitate" and has its roots in Greek. What factors facilitate is trade, and they do this by removing the risk of open trade credit. While factoring has been around for hundreds of years (Martin Luther's father ran a factoring operation), it found its way to America during the time this country was being settled. When trade began between England and the New World, open credit took on a whole new meaning as shipments going from one side of the Atlantic to the other would have a collection cycle of many months, with the increased risks of pirating, ships sinking, and of course, collecting from an entity thousands of miles (and an entire ocean) away. At this time, factors stepped up and guaranteed merchants that, if they shipped to certain pre-approved entities, the factor would make good on the debt should payment not be made within a specified time. Absent these factors, "free trade" would have been sharply curtailed.
Today's traditional factors have been around for an average of 50 years and most are part of larger, financial conglomerates. Their main purpose is to provide credit and collection services for a fee. Operationally, the factor pre-approves and sets credit limits for all its client's customers. The clients will send the factor their sales (invoices) as they are generated, notify the customer that the factor is now handling collection (so that the remittance address is changed) and will pay a set percentage of these sales (.25 percent to 1.5 percent on average) to the factor. In return, the factor guarantees collection. If no payment is received in 120-180 days, the factor pays the client. For maturity factoring, the factor pays on the invoice due date. This form is more expensive, but it gives the client a sure and steady cash flow. Also, clients can often obtain lines of credit tied to their accounts receivable from an affiliate lender of the factor because, from the lender's point of view, the collateral is literally being managed in house.
Why pay a factor when credit insurance does much of the same thing? First, traditional factors specialize in the aforementioned industries and concentrate on sales to retailers (although, sales to wholesalers have become an increasing percentage of their volume). This long history of primarily rating retailers of textile goods has endowed these traditional factors with proprietary credit information unparalleled by even the largest credit reporting agencies or credit insurers. Simply put, to this market, they provide superior credit information. The second primary benefit provided by these factors is their relative collection power. Well over half of the textile vendors that supply to retail use factors, and most of this activity is concentrated in just a handful of factors. Therefore, when one of these factors is owed money by a company, the trade debt represents hundreds of vendors. So, although losing a single vendor because of late payments might not bother a large company, losing hundreds of vendors all at once would be quite a different story. Simply put, factors get paid on time!
In order for a company to qualify as a traditional factoring client, it must have a track record (1-2 years in business) and meet some minimum sales requirement ($1-2 million annually). The firm must also be able to demonstrate adequate collection practices because the factor's mere presence and ultimate guarantee just about describe the extent of their collection work. All daily collection tasks are the responsibility of the client firm and must be kept up in order to collect on the guarantee. It is important to emphasize that these factors typically provide no lending services. Should a client wish to borrow against factored accounts receivable, the factor will walk the client's loan application down the hall to the lending group for their action. Having A/R factored can increase the chances of obtaining accounts receivable financing by the factor's lending affiliate or even by a third party such as a bank.
Small-Business Factoring: Credit or Finance?
For those companies not meeting the above parameters (basically all small businesses and all other firms not in those industries), there is a new breed of factor that has emerged to fill the void. This new breed is dramatically different from their traditional counterparts. Careful scrutiny by today's credit and collection manager is needed to ensure that the services required can be delivered.
The major difference between the traditional factors and the small-business factors is that the latter are primarily engaged in the business of financing, not credit and collection services. Operationally, clients will send invoices to the factor as they are generated. When the factor can verify delivery of the underlying goods or services, it will advance funds (approximately 80 percent of the face value of the invoice) to the client and then send out the invoice to the client's customer with a stamp on it notifying the debtor that the factor now owns title to the invoice and, therefore, must be paid directly. This essentially turns open credit into cash on delivery and greatly enhances the client's cash flow. When the invoice is paid to the factor, it will deduct the fees (2 percent to 6 percent on average) and send the client the remainder. While this works well for cash flow, it fails to address what happens when the invoiced company doesn't pay.
Full Recourse or Non-Recourse Factoring
Of primary concern is the type of factoring being offered: full recourse or non-recourse. As stated earlier, most small-business factors exist to provide financing, not credit services. Therefore, while credit reporting is a service provided by this new breed, credit guarantees rarely are. Typically, credit reports are gathered from the usual sources (TRW and D&B) and then interpreted by the factor's credit people in order to derive customer credit limits. These can be valuable if the client firm doesn't have anyone on staff with formal credit training. Otherwise, the client can purchase the credit reports directly with no factor involvement. For full recourse factoring, the factor has full recourse back to the client should the invoiced company not pay for any reason. In other words, there is no credit guarantee. Non-recourse factors will guarantee the solvency of the debtor. Therefore, should a purchased invoice not be paid because of insolvency, the factor cannot go back and demand repayment of the advance. Note, however, that only the advance is guaranteed, not the whole invoice amount, as with the traditional factors.
Full recourse factors have no incentive to do collections because the client ultimately bears the risk of non-payment. So, don't expect much help, even if they claim to provide collection services. The non-recourse factors almost always provide collection services because it is their money on the line. In contrast to the traditional factors, which are huge, long-standing institutions, the small-business factors tend to be small, new firms. Their client base is also small, so they carry no clout in the collection process. In fact, because their earnings are typically tied to the length an invoice remains unpaid, collections may actually slow when turned over to the small-business factor (unless no collections were performed previously; then, average turn will remain unchanged or improve).
Can the Factor Deliver?
The question is whether the small-business, non-recourse factor can deliver. This is a particularly pertinent question, given the make-up of this budding new niche of factors. The recent surge in numbers is due primarily to the many layoffs in the banking industry. Consequently, many players are local, mom-and-pop type companies with healthy lines of credit. This also explains why there are more full recourse factors than non-recourse. Most of the new owners of small business factoring companies came from the lending arena, so they concentrate on this side of the business while only providing minimal credit and collection services. Here again, because many of the small-business factors are small, new companies themselves, their ability to take a substantial credit loss is oftentimes not much better than their client's. So, if you are relying on a non-recourse credit guarantee, make sure the factor has the financial strength to make good on it. There has been a rash of small factoring firms going bankrupt in the past several years, and their clients suffer greatly when this occurs.
Traditional factoring is synonymous with credit and collections. Should you qualify for a program at one of the handful of these firms, the credit information and guarantees, as well as the collections clout provided, can be well worth the fees. You'll still have to perform daily collections, but only for miscellaneous issues such as returns and allowances. No one will delay your cash just for the sake of the float. You'll also still be involved in the credit management function, but, here again, the factor's superior information and credit guarantees should make your job easier if your firm sells to retail. For those that don't qualify with the traditional factors, there is a new breed out there specifically designed to fill the void. Many factors are designed more for finance than for credit and collection services, but a true non-recourse factor provides both. If you find one, make sure the contract provides credit guarantees and that the factor is financially capable of making good on it.
Thomas G. Siska is executive vice president for Concord Growth Corporation in Palo Alto, CA, a nationwide small-business financing and factoring firm. He has been in the small-business factoring arena since 1984. E-mail firstname.lastname@example.org
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|Author:||Siska, Thomas G.|
|Date:||Mar 1, 1997|
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