6 “Gotchas” to Look Out for in Factoring Contracts
November 20, 2020 |
Factoring companies are notorious for inserting tricky clauses, confusing terms and excessive fees into contracts. Learning how to spot those critical phrases can help you avoid terms and prices that can add unnecessary stress for your business.
The challenge of finding quick financing to improve cash flow often leads entrepreneurs straight to the doors of factoring companies.
Invoice factoring is a form of asset-based lending (ABL) that uses a company’s accounts receivable (AR) as collateral.
A business sells its AR at a discount to an external financing company. That financing company, often called a “factor,” advances cash based on a businesses’ uncollected invoices. This allows factoring clients to build cash flow instead of waiting 60 days or longer on customer payments.
In return, factors typically advance 70% to 90% of invoice totals upfront. The remaining balance is remitted when the invoice is paid, minus a fee.
On the surface, these terms are attractive, especially when companies are strapped for cash and need quick financing.
However, factoring contracts often lack transparency, locking their customers into long-term contracts that are costly and difficult to get out of.
Before you sign a factoring agreement, consider these six stipulations:
By design, factoring fees aren’t easy to figure out. Typically, factoring companies charge in two ways:
- Daily rate structure: The factoring fee increases every day a factored invoice is outstanding.
- Tiered rate structure: The factoring fee increases every 10 to 30 days an invoice is outstanding.
While factors often give favorable rates and fees at the outset, additional costs and add-on fees can increase the actual cost of the original quote. Look out for these extra charges in your factoring agreement:
- Breakup fees: Some factoring companies require businesses to sign a contract for a guaranteed length of time. If you terminate the contract before the end date, you may be charged a termination fee.
- Monthly minimum volume: Requires your company to continue to submit invoices totaling a certain amount to the factor each month. If you fail to meet this monthly minimum, you must still pay this minimum fee.
- Account or origination Fee: This is a one-time fee factoring companies charge for opening an account and assessing your credit background.
- ACH or wire fees: These fees apply any time funds are wired to your bank account. Ask if you can get factor payments deposited directly to your bank account to avoid these charges.
- Service or “lockbox” fee: A factor might keep a separate account to collect invoice payments and may charge an extra operating fee for the “lockbox.”
- Credit check fees: If a factor performs credit checks on your customers, it may charge your company for those tests.
Most factoring agreements automatically renew for another term without termination notice — usually 60 to 90 days prior to the end of the initial term.
It’s easy to get stuck in these types of contracts, especially since they can lock you in with high cancellation penalties.
Look for factoring companies that offer agreements with 30-day cancellation clauses, which could help if you forget to terminate your contract on time.
3. Float days
The ‘float’ period is the amount of time it takes the factor to apply payments it receives. Just like a bank, transactions are not automatically credited to the receiver’s account. Usually, the waiting or ‘float’ period lasts up to three days since the payment was made, but may vary based on the amount sent.
In financing relationships with daily or simple interest rate structures, float days aren’t problematic. However, in tiered fee structures where the fee gets larger as the invoice ages, “float” days could end up having a large impact on the true cost of factoring.
For example, a factoring company charges 1.5% for an invoice that is 16 to 30 days old and 2.5% for an invoice that is 31 to 45 days old. If a customer pays on day 28, given the three-day float period, the invoice is not credited until day 31. That means the three-day waiting period placed the invoice in a more expensive tier and actually created a 66% increase in fees.
Check for this stipulation in the section of your agreement that outlines the computation of interest.
4. Recourse vs. non-recourse
Recourse factoring means that even after you’ve sold an invoice, you’re still liable for whether it gets paid or not. If the factor can’t collect on an invoice, you’ll have to pay the full amount.
With non-recourse factoring, the factoring company buys the invoice and assumes the risk of non-payment.
Although non-recourse factoring seems like the better option, this type of financing can include a high premium and even a credit insurance policy to cover the factoring company in case of delinquency. Companies that want to go this route need customers with spotless credit for factors to consider the option.
While factoring can free up funds quickly, the process still involves some time-consuming paperwork. But if you can parse through the various legalese in factoring agreements, you’ll be able to make an informed decision on whether this type of financing is right for your business.
Here are some of the most common terms:
- Term requirement: Locks your company into factoring a certain amount of your invoices (often all of them) through the factoring company for six months, a year or even longer.
- Customer or concentration limit: Limits how much of your funding can be used on invoices from a single customer.
- Additional reserve: Provides additional cushion for the factor in case you use too much of your credit limit. Many factors use this reserve money without supporting data in cases where you draw more than 90% of your availability.
- Factoring reserve: The amount of money the factoring company keeps after paying a cash advance on your invoice. If you get a 90% advance, the factor keeps 10%. Eventually — depending on the terms of the contract — you will get a portion of that 10% back, minus the amounts of uncollected invoices, as well as other fees and penalties, and the interest rate charged as part of the contract.
- Guarantee: Requires you to personally guarantee the advances your company receives in the event that your customer doesn’t pay the invoices that you have assigned to the factoring company.
- Ineligible invoices: The factoring company reserves the right to refuse any invoices you submit for any reason. Many factors exclude invoices from overseas customers, customers personally related to you and past-due accounts.
- Credit limit: How much in invoices (gross amount) the factor will purchase from you at any one time.
- Invoice repurchase: When and under what circumstances you have to repurchase invoices sold to the factoring company.
- Additional collateral support: Any additional collateral required for the factoring company to feel secure. This may include a lien on your house, office facility, or other assets.
6. No exit
Long-term contracts commit customers to factoring-eligible accounts receivable for long periods of time — usually six or 12 months. Even if you decide factoring is no longer the right move, you could still be locked into financing you don’t need.
Factoring agreements lack the flexibility that other funding options provide. For instance, if you’re looking for help specifically with end-of-quarter needs or seasonal cash gaps, you want access to working capital on your terms — when and how you need it.
A better way
If you aren’t sure that factoring is right for your business, consider C2FO, the world’s leading market for working capital solutions.
C2FO puts control of managing working capital where it belongs: in your hands. Whether you’re looking to get paid sooner, improve cash flow, or shore up your balance sheet, our easy-to-use platform offers the control and flexibility to compare your options, set your parameters, and make the critical cash flow decisions that benefit your company.
There are no banks, fees, debt or commitments. Use C2FO to accelerate payment of customer receivables when you want and at rates that meet your needs.
To learn more about C2FO’s Early Payment solution, visit https://legacy-site.c2fo.com/vendors/.
Sources: Investopedia, Finance-monthly, Gatwaycfs, BlueVine, Bench Accounting