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Factoring Accounts Receivable – Understanding your factoring agreement.

Oct 29Dave Saunders

Factoring can be a good method of accelerating cash flow for many small and mid-size businesses, but it is important to understand the contract that you are entering into with the factoring company.  Thoroughly understanding the contract and its associated terms will help you understand the costs and limitations imposed by the contract and help you develop processes to maintain compliance with its terms.   Failure to maintain compliance with contract terms can result in an abrupt termination of the financing agreement and a requirement to immediately repay amounts that have been advanced to your business.

Some of the key items that you want to pay attention to in the factoring agreement include:

  • Discount Rate and Fees – Many factoring arrangements include a $1,000 to $3,000 initiation fee which is payable upfront.  The discount fee is the percentage of your invoices that the factor will charge for advancing cash against the invoice.  Keep in mind that a 1.5% discount fee equates to an effective 18% annual interest rate against a 30 day advance and that discount fees often increase as invoices become older.
  • Eligibility – Factoring agreements will specifically state which accounts receivable invoices are eligible for factoring.  Those typically excluded will include older invoices, customer balances with significant percentages of older invoices, customer balances with poor credit history, customer balances that are an unusually high percentage of overall accounts receivable and services provided with higher risk of disputes or defaults.
  • Guarantees and Liens – Most factoring agreements will require the business owner to personally guarantee the repayment of

    amounts advanced.  They also require a lien against all assets of the business and a UCC filing will be made to record the lien.  This asset lien may limit your ability to seek and become approved for other less costly forms of financing.

  • Term – Most factoring agreements are long-term contracts requiring that all eligible accounts receivable be factored over its term.
  • Advance Rate – Most factoring agreements allow for an advance of 70-90% against eligible accounts receivable.  You don’t always have to take the advance if you don’t need the cash, but cash collections will always be collected through the factor’s lockbox account which may even be located in another city or state.
  • Customer Interaction and Notification – Understand whether your customer will be notified of the factoring arrangement or whether factoring will be done on a confidential basis.  Also, it is critical to understand the rights that the factor has to interact with your customers in the event of account delinquency or dispute.  Keep in mind that most agreements allow the factor to directly contact your customer for payment and to communicate with your customer without limitation to settle indebtedness.  Get a feel for the professionalism and personality of the factoring company before you sign the agreement and check references carefully.
  • Recourse – Understand who will be financially responsible for the collection of debt and who bears the risk of loss if amounts are not paid.  Most factoring agreements place responsibility for risk of loss and collection with the business owner but also allow the factor to communicate with your customer in a tone and manner in which they see fit.
  • Events of Default and Covenants – All factoring agreements will define events of default which can terminate the factoring arrangement and a set of positive and negative covenants that your business must abide by.  One extremely important covenant is that customer payments for factored invoices and related account balances must be made through the factor’s lockbox account and NEVER provided directly to your business.  If your business receives a payment from a factored account, the factor must be informed immediately of the error and the payment must immediately be sent to the factor and never cash by your business.  Although

    mistakes in this area may be perfectly innocent and without any negative intent, diverting cash is one of the leading breaches resulting in termination of a factoring agreements.   There can also be financial covenants connected with factoring arrangements which are tied to financial performance and the financial position of your company.  Be sure to understand what type of performance is required and how this may limit your ability to make investments, withdraw cash and seek other financing.

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