How is a Subordination Used in Invoice Factoring?

Summary: In most cases, setting up a factoring account is relatively simple. Once the factoring contracts are signed, the factor files a UCC lien to secure its position against the accounts receivable, sends notices of assignment, and starts funding the account. Usually, this process is done fairly quickly.

Having an existing UCC lien claiming your accounts receivable as collateral delays the funding of a factoring account. This lien prevents the factoring company from securing its position against the invoices it’s financing. Consequently, the factoring company cannot finance the account until the issue is resolved. This challenge can happen if your company already has financing or a tax debt. This article explains how liens work in factoring, what lien subordinations are, and how they are used in certain transactions. We cover:

  1. What is a lien?
  2. What is a subordination?
  3. Is there another lender involved?
  4. Is there overdue tax debt?
  5. Why would a lienholder subordinate their lien position?

1. What is a lien?

A lien is a legal tool companies or authorities use to secure a priority position when claiming assets as collateral. Most business loans are secured by filing a lien against the assets of the company. This lien often includes accounts receivable and uses notations such as “all accounts,” “accounts receivable,” or simply “all assets.” Taxing authorities can also file a lien to secure collateral if taxes are owed to them.

Liens usually work on an order-of-placement system. The first lien placed against an asset has a first-position priority on that asset. Subsequent liens, such as second or third liens, are junior. The order of priority is important in the event of a default. Debt associated with higher-priority liens must be satisfied before junior lienholders can be paid.

Note: This is a very general explanation of how liens work.

2. What is a lien subordination?

Factoring companies must have a first-position lien against the assets that secure their transaction. At a minimum, the factor must have a first-position lien against accounts receivable before being able to buy your invoices.

Prospective clients can encounter problems if they try to get a new financing line but already have an existing line secured by company assets. This problem can be bridged if both parties agree to a subordination using an inter-creditor agreement. A party that subordinates its lien agrees to place it at a lower priority position and allows another party to take a higher position.

3. Is there another lender involved?

You often encounter a collateral problem if you have business financing in place and try to get a factoring line. Your existing funding likely has a first-position lien against your assets. The factoring company won’t be able to proceed unless your existing lender agrees to a subordination. For this reason, combining existing loans with a factoring line is difficult.

However, you may want to explore why you need factoring if you already have a line of credit or MCA in place. There are usually two possibilities. One possibility is that your company grew faster than expected. Thus, the original line is now undersized. If this is the case, consider replacing your existing financing with a better solution.

A second possibility is that the company ran into problems and has exhausted its funds. The owners hope a factoring line may help improve cash flow while management turns the company around. Unfortunately, this approach seldom works since most lenders consider the company over-leveraged. The better alternative is to work with an expert to restructure your current lending.

4. Are taxing authorities involved?

Federal and state taxing authorities can also file a lien against a company if you have overdue taxes. Most tax liens encumber all assets and have certain priority rights. For this reason, factoring companies ask for tax documents as part of the application process. Lenders usually require that the tax problems be handled before providing any financing. Otherwise, they risk having a lien in a junior position to taxing authorities.

5. Why would a lienholder subordinate its position?

Getting a lien subordination from another lender is difficult. You have to prove to the lienholder that they are overcollateralized or that subordinating their lien will benefit them. Let’s explore each of these positions in more detail.

a) Lender over-collateralized

A lender is over-collateralized when the value of the collateral they hold is substantially higher than the value of the loan. From a lender’s position, being over-collateralized is safe. It means they have a good chance of recovering all funds in the event of default. Lenders have the incentive to remain over-collateralized. Convincing them otherwise is difficult.

There is one common exception. Some equipment lenders file “all asset” liens even though the loan is specifically secured by the equipment. Equipment lenders are usually open to subordinating their position on accounts receivable and assets not related to their loan.

b) Subordinating benefits them in the long term

The only other way you can convince a lien holder to subordinate its position is to show how the subordination benefits them. The typical argument is that the factoring line will help your company grow. Consequently, the lender’s position on their other collateral is presumably more secure. Lenders seldom agree with this premise. It’s in their interest to keep their loan well collateralized. On the other hand, taxing authorities are usually open to this premise. A taxing authority may agree to subordinate its position if your company agrees to a payment plan. Taxing authorities may require that your factoring company make the monthly payments on your behalf using part of your factoring advance or rebate.

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Note: Consult an attorney. This article is for informational purposes only, as it oversimplifies what can be a complex matter. If there is a lien against your company, consider retaining an attorney to help you determine the best course of action.