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What do you do when you find yourself in need of capital, but can't get (or don't want) a traditional bank loan? For business owners in need of fast cash, using a factoring service may be the answer.
Factoring is an alternative method of financing that allows business owners to sell their invoices, or accounts receivable, to a third party (also known as a factor) for a certain percentage of their value. This percentage differs among factoring services, but it's generally around 80 percent, meaning you'll get most of your money up front. The factor then collects your customers' payments and forwards the rest of the cash to you, after deducting their service fee, which usually falls between 2 and 6 percent of your total invoices.
Given that factoring gives business owners a way to receive cash almost immediately, it may seem like the ideal financing option. But factoring isn't always a viable option for business owners. While it is a viable solution for B2B businesses, where the accounts receivable are businesses, not individuals.
"[Factoring won't work] when the invoice is from a business to an individual consumer," said Eric Grozenski, assistant vice president of factoring company RMP Capital Corp."Medical receivables, real estate and insurance receivables are tough to do, but there are some factoring companies that will get involved."
It's also important that you realize the difference between a collection agency and a factoring company, and that you use the correct service for your needs.
"Factoring companies are not collection agencies. Businesses should not use factoring for when they know there is going to be a problem collecting on invoices," said Scott Applegate, chief operating officer of factoring company CapitalPlus Equity, also noting that factoring is not a solution for companies in dire financial situations.
"If a company has substantially more accounts payable than accounts receivable, factoring is probably not a good idea," Applegate said.
So how do you know if your business can use a factoring service? Stephen Perl, CEO of factoring company 1st PMF Bancorp, said it all comes down to a few simple characteristics.
"Many small to medium-sized businesses can benefit from invoice factoring if they have two characteristics. One, their clients are businesses, and two, if they are providing 30- to 60-day terms," Perl said.
If your business meets these criteria, you should be well on your way to factoring success.
Benefits of using factoring services
The most notable benefit of using a factoring service is that it gives you almost immediate access (generally within 24 hours) to the cash you need, however, there are many other positives that make factoring a great funding option.
When it comes to traditional loans, the pressure is on you and your business to prove you can pay them off before you even get approved, but with factoring, it's not about you – it's about your customers.
"Where banks will consider whether your company is financially sound when deciding to approve a loan, factoring companies don't look at the size of your business or your creditworthiness. In fact, factoring companies look at the creditworthiness of your customers," Applegate said.
For small business owners who find it difficult to get loans, this can be an excellent alternative. Grozenski noted that with factoring, you get the opportunity to work with an entrepreneurial-minded lender who understands small business.
Grozenski also said that factoring services can help you speed up cash flow, and as an added perk, you can use your factoring service's credit department to evaluate new customers.
And, of course, factoring cuts down on wait time. Without it, you may need to wait 45, 60 or even upward of 90 days to collect on your unpaid invoices, Applegate said.
Factoring service pitfalls
Our experts agreed that the only real downside to using a factoring service is that, when compared to other financing options like traditional bank lending, factoring can be more expensive. The service fee may seem small, but it can add up depending on how much you have in invoices.
While factoring is a costly service, Applegate noted that for some businesses, the steeper price is worth it.
"Factoring may be more expensive than some other options, [but] it can be a perfect working capital solution for you as long as your opportunity cost outweighs the factoring cost," Applegate said.
Grozenski also noted that disregarding factoring as an option simply due to the cost could leave business owners with missed opportunities.
"While factoring is not the lowest cost of financing a company, they must look at the opportunities they are missing by not factoring. They must also view it as a period of time and realize that it can help them expand or recover while getting to the ultimate place they want to be," Grozenski said.
How to choose a factoring service
When it comes to selecting the right factoring service for you, Perl said that first you should consider your business's needs.
"It'simportant to evaluate your needs and your company before just calling any factor because if your business does a lot of importing for exporting, there will be only a few factors able to handle this type of transaction smoothly and with experience," Perl said. "Small businesses need to have a global perspective and know if their business needs these items in the future as well."
Beyond just evaluating the needs of your business, you should also make sure that your factoring service has experience dealing with your particular industry. Don't settle for a one-size-fits-all lender, Applegate warned.
"A jack-of-all-trades is a master of none. When you want the best results, you go to a specialist, not someone who dabbles in a little bit of everything." Applegate said.
Applegate also said that business owners should be sure that the factoring service they choose is customer-service oriented. Look for a factoring company that will treat you as a partner and maintain a high level of customer service when dealing with your clients and customers, he advised.
And when it comes to your relationship with your lender, Perl said it's important to be able to meet with your potential factoring service.
"Invoice factoring is very relationship-driven and your business could have large benefits if the factor really knows you and your staff," Perl said, adding that you should talk to management – not just sales staff – and make sure you're really comfortable with the company.
Before you select a factor
Thinking about using a factoring service? Before you decide to pursue factoring or choose a lender, our experts said you should ask yourself these 10 questions:
- Are we having cash flow problems?
- Is our business too new to qualify for traditional lending?
- Do we have a gross margin over 20 percent?
- Do we need factoring year-round or seasonally?
- Do we need a lot of capital, or just small advances?
- Can our current lender keep up with our growth?
- Does this factoring service's terms meet our needs?
- Is this factoring service experienced in our specific industry?
- Do we feel comfortable trusting this lender/factoring service?
- What level of service can we (and our customers) expect from this factoring company?
Your answers to these questions should help you determine what your funding needs are and whether or not a factoring service can help you meet those needs. If factoring sounds like the right option for your business, be sure to consider your research as well as your responses to find the best factoring service for you.
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