Finance and Lending
6 ‘Gotchas’ to Look Out For in Factoring Contracts
December 8, 2022 |
The C2FO Team
Factoring contracts can contain confusing terms and excessive fees that negatively impact your business. Here’s what to look for in the fine print.
Factoring contracts can be misleading and exploit small and mid-sized businesses in need of access to fast funding. Invoice factoring may seem like a quick and easy financing solution when your business is experiencing cash flow gaps. However, before you sign a factoring contract, it’s critical to ensure you understand how it works so you can spot any potential red flags.
Invoice factoring is a form of asset-based lending that uses a company’s accounts receivable as collateral. A factoring contract is an agreement to sell your outstanding invoices at a discount to a third party — also known as a factoring company — in exchange for cash upfront. This can enable you to access cash much more quickly than waiting 60 days or longer for customer payments. Factoring companies typically advance 70% to 90% of invoice totals upfront. They remit the remaining balance when the invoice is paid, minus a fee.
On the surface, these terms can sound attractive, especially when companies are strapped for cash and need quick financing. However, factoring contracts often lack transparency, locking customers into long-term contracts that are costly and difficult to get out of. Like with any financial agreement, before you sign a factoring contract, it’s important to do your research. Here are six key things to consider in factoring agreements:
1. Know what fees to watch for in factoring contracts
Factoring fees refer to the discount rate factoring companies withhold as payment when they purchase your invoices in advance of their due date. By design, factoring fees aren’t easy to figure out. The fees are typically calculated by applying a factoring rate either on the amount advanced or on the face value of the receivables depending on the agreed-upon rate structure. 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 may offer favorable rates and fees at the outset, additional costs and add-on fees can increase the actual cost beyond the original quote. Look out for these extra charges in your factoring agreement:
Breakup fee: Some factors 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 fee: Some factoring companies require you to continue to submit invoices totaling a certain amount to them each month. If or when you fail to meet this monthly minimum, you are required to pay a minimum fee.
Account or origination fee: This is a one-time fee that some factoring companies charge for opening an account and assessing your credit background.
ACH or wire fee: These are charges that will apply any time the factor wires funds to your bank account. To avoid these fees, you can ask the factoring company if it is possible to have your factor payments deposited directly to your bank account.
Service or “lockbox” fee: A factor might keep a separate account to collect invoice payments. This account, where funds are held until customers pay invoices, is called a lockbox. Some factoring companies charge an extra operating fee to maintain this account.
Customer credit check fees: Some factoring companies charge credit check fees for each new customer. If you have a lot of customer turnover, it’s in your best interest to look for a factor that either has low or no credit check fees.
2. Look out for an auto-renewal clause
An auto-renewal clause is a component in a factoring contract that allows the factor to extend your original agreement term and continue billing you, without requiring your re-approval.
If you sign a contract with an auto-renewal clause, you could be on the hook for the next term if you don’t cancel within a specified time frame. Many 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 this type of factoring contract if you aren’t careful, especially since these contracts can lock you in with high cancellation penalties.
Look for factoring companies that offer agreements with 30-day cancellation clauses, which could lower the cost if you forget to terminate your contract on time.
3. Consider the cost implications of “float” days
“Float” is a key variable that can have a significant impact on the true cost of invoice factoring. A float period refers to the amount of time it takes the factor to apply payments it receives. Similar to a bank, payments are not instantly credited to the account. Generally, the waiting or float period lasts up to three days, but it can 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 can increase your financing costs by more than 40%. In these structures, the float is similar to a hidden fee that the factor uses to increase its returns at your expense.
For example, if 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, and 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 created a 66% increase in fees.
Because float days can result in higher costs, it’s imperative that you check factoring contracts for this stipulation in the section of the agreement that outlines the computation of interest.
4. Understand how recourse and non-recourse factoring differ
There are two main types of factoring — recourse and non-recourse. Recourse factoring is the most common type and means that even after you’ve sold an invoice, you’re still liable for whether it’s paid or not. If the factor can’t collect payment on an invoice, you’ll ultimately be responsible for paying the full amount.
With non-recourse factoring, the factoring company buys the invoice and assumes the risk of nonpayment. Although non-recourse factoring seems like the better option, it doesn’t necessarily protect your company from all risk. There are usually strict stipulations, and the situations in which you are not responsible for customer nonpayment are very specific.
For example, many factoring companies only offer non-recourse if the customer declares bankruptcy. This type of agreement is usually only considered as an option for your customers that have an exceptional credit rating. Customers with below average credit (with higher risk of nonpayment) generally aren't eligible for non-recourse factoring.
Additionally, non-recourse factoring typically has higher rate premiums and may even require a credit insurance policy to cover the factor in case of delinquency. With this in mind, it’s important to consider whether the higher rate is worth the extra cost.
5. Master the tricky legalese in factoring contracts
While factoring can help to free up funds quickly, the process can still involve some unfamiliar terms and time-consuming paperwork. To make an informed decision about whether this type of financing is right for your business, you’ll need to be able to parse the legalese in factoring agreements.
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 an 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 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. Review the provisions for contract termination
Many factoring agreements have details and rules pertaining to the length of the relationship. Long-term factoring contracts can commit you 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. Therefore, it’s vital you understand the full implications of terminating your factoring contract.
You will have the right to terminate a factoring agreement, but a term length is usually outlined in the agreement, as well as rules for how far in advance this must be done to avoid renewal or cancellation charges.
Why dynamic discounting is a better option
With APRs often above 30%, invoice factoring is one of the most expensive ways to boost cash flow. It also lacks the flexibility of other innovative funding sources, like early payment programs. For instance, leveraging an early payment program that offers dynamic discounting can help you accelerate customer payments and bridge cash flow gaps — without entering a misleading contract or increasing debt. Programs like this also cost substantially less than factoring services and give you more control over the whole process.
Both factoring and dynamic discounting provide access to working capital by discounting your invoices. However, with dynamic discounting you:
Gain access to working capital on your terms — when and how you need it.
Receive the full amount of your invoice upfront, minus the discount.
Choose which invoices to accelerate and at what rate.
Maintain full ownership of your invoices.
Pay substantially less in fees.
Do not take on new debt.
Avoid misleading contracts.
Are you interested in leveraging dynamic discounting to accelerate cash flow for your business? Learn more or get started by searching for your customers today.
This article originally published November 2020, and was updated December 2022.