The decision to use factoring to improve the cash flow of your company is not easy and should be done carefully. The success of your business depends on making the right choice and partnering with the right company.
In this article, we discuss how to evaluate factoring companies effectively. The process is simple to use and will shorten the time it takes you to make a decision. It involves asking the factor questions in eight critical areas. Once you have collected this information, you can compare their answers and make your choice. Here is a link to a PDF version of the questionnaire that you can use during this process.
#1 How long has the factor been in business?
The factoring market is competitive and dynamic. There are new companies coming into the market every month. It’s important to determine if you are working with a new or an established factor early in the evaluation process. This point is critical because your company is usually better off working with an established factor.
Running a factoring company is difficult and requires careful risk management. Most new companies have not been around long enough to demonstrate long-term management capabilities of their clients. This inexperience puts your company at risk. One of the worst possible outcomes for you would be for your factor to go out of business.
You want to work with a factor that has been around for at least five years. However, more experience is better. This will give you some confidence that they know what they are doing.
This does not mean that every young factoring company is necessarily a bad choice. But if you do work with a new company, it does mean that you must dig deeper and research the management of the company. If the company is new, you want to make sure that the owners and underwriters have sufficient industry experience (5 to 10 years). An easy way to determine this is to review the profiles of key managers via LinkedIn.
#2 Does the factor have clients in your industry?
Most factoring companies claim to be generalists. They advertise that they can work with businesses in any industry as long as they are dealing with solid invoices for delivered products/services. For the most part, this claim is true.
However, you are always better served if you work with a company that has experience with your industry and has active clients in it. Every industry has its own invoicing practices – and nuances. Working with an experienced company helps you avoid issues.
Determining if the factor works in your industry is simple. Ask them to provide references in your industry. If you decide to work with this factor, contact those references before making a final decision.
#3 Is the factor comfortable with your sales volume?
Most factoring companies claim that they can work with clients of all sizes. Their advertising may even say that they can handle clients from $5,000 to $5 million. As you can imagine, managing a $5,000 client requires a different set of skills than managing a $5 million client. It’s not easy to offer everything to everybody.
While the factoring company can probably fund accounts in the range they advertise, it doesn’t mean they are good at it. Most factoring companies have a financial comfort zone, or “sweet spot”. This is where they have most of their clients.
In our previous example, the factor that works with clients from $5,000 to $5 million may have a sweet spot of $150,000 to $350,000. This means that most of their clients need financing within that range. These clients usually get the best terms and services.
You can find out their sweet spot easily by asking them. Most factoring companies are happy to tell you about their comfort zone.
#4 Does the factor require minimum factoring fees?
Some factoring companies charge a minimum factoring fee. With a factoring minimum, your company commits to factoring a regular volume in exchange for better financing rates. If your factored volume falls below your required minimum volume, the factor charges you an additional fee. This fee ensures that the factor derives a minimum amount of revenue from your company.
Committing to minimums ensures that your company gets good pricing. However, minimums can be a double-edged sword. If you don’t meet them, your company is forced to pay the minimum fees. Ultimately, this can make your factoring costs expensive.
If you choose to commit to factoring minimums, do so strategically. Choose a minimum that you are certain you will meet. This helps keep your financing costs in check.
#5 Does the factor require a long-term commitment?
Some factoring companies operate on a yearly agreement. If you want to break the contract, the factor usually asks you to pay an early termination fee. These fees can be hefty and are put in place to discourage companies from early termination.
Discuss this issue with the factoring company early on. If possible, work with a company that does not require a long-term commitment. Think about it this way: if their service is so good, why do they need long-term contracts?
There is one exception to this rule. Factoring companies that work in complex transactions that have a high level or risk often ask for year-long commitments. This request is reasonable since it allows them to reduce their effort and risk.
Try to negotiate a three- to six-month engagement with an automatic extension. Alternatively, work with factoring companies that offer a “test drive” of their plans. This approach allows you to set up the factoring plan and put it into practice. It also gives you a window to leave the factoring agreement if it has outlived its usefulness.
#6 Are the factor’s advance and fee structures competitive?
Most business owners evaluate a finance proposal by simply looking at the rate and asking about application fees. Unfortunately, this is a sure way to end up with the wrong deal. The best way to evaluate proposals is to look at the cost per financed dollar, which takes the advance and the rate into account.
Most business owners think that the cost of factoring is determined only by the rate. This thinking is incorrect. The cost of factoring is determined by the advance, the rate, and other fees. For a detailed explanation, learn how to compare factoring rate proposals. Also, here is some information on typical factoring rates.
#7 Do they offer good service?
Every factoring company advertises their service as being the best. Service is a feature that is hard to measure from the outside. However, you should not take the factoring company’s claims at face value. You need to do your own due diligence to verify the claims.
Ask the factor for a list of references, ideally in your industry. This is a good place to start. However, you can be certain the factor will give you the names of only their best clients. So it’s up to you to ask good questions to help uncover issues. Ask questions such as:
- How quickly do you get funded?
- How quickly to they pay rebates (or return reserves)?
- How do they communicate with your customers?
- How could they improve their service? (this approach is more effective than asking about shortcomings, but it’s essentially the same question)
#8 How is the factor funded?
Lastly, you should know how your factoring company is funded. Just like your business, most factors need external funding to operate. Usually, sources of funding include owners assets, bank financing (e.g., a line of credit), and market instruments.
Unfortunately, there is no “best” way to finance a factoring company. All financing methods have a level of risk. You just have to evaluate how they answer this question and decide if you are comfortable with that. If you can, perform some due diligence on their funding sources. In general, companies that have been around for a while – see question #1 – have a stable source (or sources) of financing.
For more factoring resources, consider reading our article “How to Choose a Factoring Company.”
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