Summary: A ledgered line of credit (LLOC) offers a good alternative for companies that have outgrown their invoice factoring facility but aren’t ready for the heavy covenants and compliance requirements of a bank line. Moving from factoring to a ledgered line of credit, or another revolving facility, requires careful coordination to ensure a smooth transition.
This article explains the general transition process and highlights issues that could affect the transaction. Keep in mind that every transaction is different, and finance companies may follow different procedures. Consequently, the exact sequence and timing may vary. The article covers the following:
Step 1. Should you move to a ledgered line of credit?
Moving to a ledgered line of credit can make sense as your company grows. Ledgered lines offer several advantages over factoring lines. However, your company must determine whether the move makes sense given its circumstances.
Often, the main reason for moving to a ledgered line is to lower financing costs. If that is the case, try negotiating better pricing with your factoring company first. Many factoring companies will consider lowering their rates to keep a good client.
Read “What is a ledgered line of credit? How does it work?” and “Ledgered line of credit vs. factoring” to learn more.
a. Volume
Most ledgered lines of credit require that you finance a minimum of $1,000,000 in monthly sales. Seasonal companies are usually exempt from the monthly minimum as long as they generate at least $12 million in annual sales.
b. Qualification requirements
There is some overlap between the qualification requirements for a factoring line and a ledgered line of credit. However, the requirements for an LLOC are more stringent and are intended for companies with strong financial controls in place. Consequently, your company must have an effective invoicing and collections process, reliable financial reporting, and good management practices.
c. Line maintenance
Ledgered lines of credit require more ongoing maintenance and compliance than conventional factoring lines. Your company must provide regular financial reports, comply with minimum usage covenants, keep lien filings and collateral information current, and meet other reporting requirements. Make sure your company’s finance team can handle these responsibilities before moving to an LLOC.
Step 2. Review the factoring agreement
Many factoring agreements, especially those for larger companies, run for a specific term and include an automatic renewal clause. Furthermore, the contract may also require your company to follow a specific notification process if it decides not to renew or to terminate the facility.
Trying to terminate the agreement before the end of its term may trigger early termination penalties, which can be substantial. Review the contract carefully to ensure you understand these requirements before notifying the factor that you intend to move to a new facility or provider.
Note: We suggest retaining legal counsel to ensure compliance with the factoring agreement while planning the transition.
Step 3. Plan your cash flow carefully
It’s possible that your company won’t be able to finance its invoices during part of the transition period. The new finance company should be able to give you an idea of how long the process typically takes. In our experience, it’s best to assume there will be some unforeseen delays. Take the finance company’s estimate as a starting point. Discuss this with your finance team and then build a reserve large enough to provide a financial cushion so you can continue to operate the business during the transition.
Step 4. Decide when to initiate the transition
This is perhaps the most critical step. Your company must carefully plan when to engage the new financing company, notify the factoring company of your intent to terminate the agreement, and begin the transition. These actions must be carefully sequenced to ensure a smooth process.
Consider working with legal counsel to plan the timing of this move. This will help ensure that you comply with all contractual provisions.
In our experience, the process works best when you engage the ledgered line of credit provider several weeks before you have to notify the factoring company of the termination. This will give the finance company enough time to complete most of its due diligence. Ideally, it should complete as much of the process as possible before contacting your customers or notifying the factoring company.
Step 5. Review and execute LLOC legal documentation
The ledgered line of credit finance company should be ready to issue the facility’s legal documents. Review the documents with your legal team to make sure the facility meets your objectives and that you understand its terms.
Consider adding a provision that allows you to terminate the contract if the closing fails for reasons outside your control. Although this is unlikely, you don’t want to be bound to a finance company if the transaction does not close.
Step 6. Get a payoff statement from the factor
Once you successfully complete the previous steps, you will be ready to ask the factoring company for a payoff statement. The statement shows the open invoices and the amount required to pay off the account and release the lien.
The factoring company generally won’t finance new invoices after this point since doing so would change the payoff amount. Note that the payoff amount may change over time as fees accrue and invoices are paid.
Step 7. Coordinate the payoff and lien release
At this step of the transition, the factoring company and the incoming finance company have competing requirements. The factoring company has a first-position lien against your company and its accounts receivable. It wants to keep that lien in place until it is paid off. The incoming finance company, on the other hand, wants its first-position lien to be in place before it pays off the factoring company.
This timing issue is typically addressed through a coordinated closing and a payoff letter from the factor. The payoff letter specifies the amount required to pay off the factoring facility and provides for the release of the factor’s lien once the required payment is received. The payoff and lien-release process should be agreed to well before the closing date.
Step 8. Pay off the factoring company
Steps 8, 9, and 10 typically happen at or around the same time. We cover them separately to make each part of the process easier to understand.
Once the payoff agreement is finalized and executed, the parties can move forward with the transition. The incoming finance company typically obtains an updated payoff amount from the factor. This amount reflects any payments received, advances made, or fees and other charges incurred since the previous payoff amount was provided.
The funds are usually sent by wire transfer. This allows the factoring company to verify receipt on the same day.
Possible issue: Payoff amount exceeds your LLOC’s eligibility
There is always the possibility that the payoff amount will be higher than the amount available under the LLOC. This can happen for several reasons, including different advance rates, credit policies, or fees.
There are several ways to handle this problem. Ask the incoming provider, in advance, how it handles funding gaps.
There are typically two options. The incoming finance company may provide a one-time “over-advance” to cover the funding gap. If this is not an option, your company may have to contribute funds toward the payoff or use the LLOC to fund additional eligible invoices and apply those proceeds to the gap.
Step 9. Complete the lien transition
The lien transition should be relatively straightforward. This process can be handled in a couple of different ways. It varies based on the transaction structure, the presence of other liens, and the parties’ legal preferences.
In many cases, the factoring company will terminate its lien while the LLOC finance company files a new lien. Alternatively, the factoring company may assign its UCC lien to the incoming finance company.
Possible issue: Last-minute delays
The lien transition can be delayed if the required releases, assignments, or UCC filings are not ready at closing. These issues should be identified and resolved in advance, so they don’t delay funding.
Step 10. Transfer customer payment instructions
The ledgered line provider will begin notifying your customers of the new payment instructions. This is typically done in coordination with your company to help ensure a smooth transition. This step can be labor intensive if your company has many customers, since the LLOC provider must verify that the changes have been made.
Possible issues: Customers continue paying the factor
Some of your customers may delay implementing the payment change until they receive approval from their management team. This can lead to situations where the factoring company receives a payment that should have been directed to the LLOC provider.
This issue is typically addressed while coordinating the payoff and lien release (Step 7). As part of the process, the factoring company agrees to remit any payments received after the payoff to the new finance company.
Step 11. Start using the ledgered line of credit
Using the line should be simple, especially if all parties performed their due diligence carefully. Most ledgered line of credit providers require that you submit a list of invoices you want to finance, along with supporting documentation as required.
Possible issue: Different eligibility rules
It is possible, though unlikely, that the amount available under your LLOC will be less than what was previously available through factoring. This can happen if the factor financed invoices that do not meet the LLOC’s eligibility requirements or if the two facilities use different advance rates or funding formulas.
Ideally, this issue should have been identified during the review of the LLOC documentation in Step 5. Comparing both facilities should have revealed any potential funding gap and allowed the parties to plan for it before closing.
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Marco Terry is the Managing Director of Commercial Capital LLC and has over two decades of experience in asset-based finance. He has worked with small and mid-sized companies across the United States, Canada, and Australia. Marco holds a Master of Science in Finance.