Financing Products: Factoring
The Situation:
Your company is experiencing the start of a major period of growth. You are booking new sales orders every day for products you manufacture in house. Some of your new orders are larger than historical order sizes, while on others you are collecting a smaller customer deposit.
To finance these orders, working capital might include customer deposits on these new orders, favourable payment terms with your suppliers, and the use of your existing bank line of credit.
Business is good as orders keep rolling in!
This situation however is not sustainable over the long-term. Eventually, your line of credit will be at its limit and customer deposits may not provide sufficient cash flow to cover the increasing expenses (e.g. inventory, labour, overhead, etc.) to meet mounting sales orders.
The Solution:
As a business owner, leveraging your existing assets (i.e. your accounts receivables) might the solution in this scenario.
Further, factoring might be the financing product needed.
We spoke with Raj Singh, a seasoned finance professional about factoring, to get her insights and perspective.
Kaeros: We’ve outlined a fictional scenario above we see all too often. In what other scenarios have you seen where factoring might be the ideal financing product?
Raj: The ideal candidate for factoring are companies that are at the start-up stage of their business life cycle. For example, those without a proven track record of 2 to 3 years of strong financial performance with positive EBITDA.
Two examples come to mind where factoring really worked well for past clients of mine.
In one scenario, I worked with a staffing company that had $10M in sales in their first month of operations, which increased to $200M a month by the end of their first year. We helped grow the company by continuously increasing their credit facility along with the increased sales. This differs from a traditional bank margined operating line which is typically slower to respond to strong growth and increased cash flow needs on a monthly basis.
In a second scenario, four new partners bought out a restructured truss company. A few challenges we encountered on this deal were that although the new partners had previous entrepreneurial experience, they had limited experience in the truss industry. Also, several of the incoming partners had below average credit scores. Ultimately, we were able to get behind the deal because the company had a strong established customer base and because management hired a full-time operations manager. Within their first month of ownership, they factored over $500M in accounts receivable, which increased to $1.5MM within one year. In this situation, a traditional bank lender would typically view such things as incoming management having no proven track in the business / industry, weak personal credit scores and limited access to qualified personal guarantees, negatively. Despite these challenges, and by gaining an understanding of the businesses growth plan and the collateral available, we were able to get comfortable with the client.
Kaeros: How does a factoring facility differ from a traditional margined operating line provided by a bank?
Raj: The major differences are as follows:
1. Typically, once a margined account at a bank is set up it won’t change until the following year-end annual review is completed. On the other hand, a factor can be more flexible, and quicker to respond to the company’s cash flow needs.
2. A factor usually collects account receivables from the debtor, while a bank will leave the company to do its own collections.
3. In general, banks only margin accounts receivables when the operating facility is over $1MM. In contrast, a factor will often buy and manage each receivable over $2,000.
4. A factor is a lot more hands on with invoicing and collecting, thus factoring is significantly more expensive than an operating line of credit. With a margined line, an A/R listing is submitted to the bank and a calculation of the eligible line for the proceeding month is established.
As a result of the above-noted flexibility provided in a factor line, as well as the risks involved, factoring will typically cost more than a bank operating line.
Kaeros: When founder’s and owner’s are thinking about taking on any form of new financing, they must consider the risks involved in leveraging their assets. When would factoring not be appropriate and why?
Raj: Generally speaking, factoring is not appropriate if a company’s financing needs can be met by a traditional lender, and where the client uses its operating facility strictly to finance working capital.
Also, factoring is not appropriate if a company’s A/R and A/P aging and inventory is not accurate and up to date. Such a situation might be the case if you are a start-up or new company. While interim financial statements would be helpful to establish a factoring facility, a smart factor can complete the initial due diligence with bank statements. Ideally, having your fiscal year-end financials up-to-date and having the capability to provide quarterly and trailing twelve-month financials, is best.
Editor’s Note: At Kaeros, we discuss the notion of Market Readiness with many of our clients, the notion that your financial house (including your company’s reporting capabilities) should be in order before you go to market.
Finally, in my experience I noticed that if a business owner couldn’t be completely transparent with me from the beginning, with respect to challenges or troubles facing the company, which were later uncovered during the due diligence process, a smart factor would not take a chance on the company irrespective of the company’s turnaround success. Factoring is a relatively risky form of financing so if the factor isn’t working with a management team it believes to be transparent and operating with integrity, the risk to the factor increases to the point they may pass on the deal.
Kaeros: There are many factoring companies in the market, both in B.C. and across Canada. In your experience, what makes a good factoring partner?
Raj: A good factor understands its clients, the industry its clients operate within and their stage in the business life cycle. They will also ask the right questions that trigger best practices. One of the best compliments I ever received was when a clothing wholesaler agreed with our terms and conditions including higher rates [vis-a-vis a traditional bank], because they felt we were there as a financial partner who understood and cared about their businesses success.
Another important aspect of a good factor is when they are transparent with pricing and terms and conditions from the very beginning. Also, its important for a factor to have flexibility, including providing options of notification and non-notification collection policies.
Finally, a strong factor will keep accurate and transparent records during the collection period. Clients can facilitate this process by submitting various documents to the factor as requested, in order to avoid extra time and cost.
Kaeros: We often get feedback from our client’s that they’d prefer to stay with their existing bank, versus working with a factoring company. We find this especially interesting when a company’s incumbent lender is tapped out on how much it will lend them, often necessitating owner’s using personal resources to finance their business. Have you heard this feedback before, and if so, what advice might you share with business owner’s about factoring and keeping their options open?
Raj: I have heard this response many times before. I’d always respond by asking my client what they thought the [lost] opportunity cost was of not taking on the extra financing in support of the new business? Time and time again, companies feel that factoring is the last resort. However having worked as a commercial banker, I know bank regulations and risk appetite is often limited when compared to factoring facilities. With factoring, decisions can be made a lot quicker as it’s the debtor’s credibility the factor is looking at. If the business owners can’t get a larger line, it’s because their business operations or the industry doesn’t merit the banks risk appetite.
Are you thinking about factoring as a potential option to finance the growth of your business? If so, please reach out for a free one-hour consultation.
Cheers, Trevor
Founder & Managing Director