Selecting a factoring company is one of the most important financial decisions that you will make for your business. This article explains everything you need to know so you can find and select the best factoring company for your business. We cover the following:
- What is a factoring company?
- How does factoring work?
- Recourse vs non-recourse factoring
- How much does factoring cost?
- What to look for in a factoring company
- How to find the right company
- What happens after you choose a factor?
1. What is a factoring company?
Factoring companies specialize in financing invoices (i.e., accounts receivable). They offer this service because many small and midsize companies cannot afford to wait the usual 30 to 60 days it takes to get paid. Companies need the funds sooner to pay for ongoing business expenses such as suppliers, payroll, rent, and so on.
Factors provide two services that work together: credit reviews and accounts receivable financing. The factor reviews the credit of your commercial customers to determine if they deserve 30- to 60-day terms. This review enables you to offer credit only to customers who will pay according to terms. Invoices due from customers with good credit can be financed through the factoring company. This service improves your company’s cash flow.
To learn more, read “What is a factoring company?”
2. How does factoring work?
Factoring transactions have a simple structure. Factoring companies usually finance your receivables by purchasing them. Most transactions are financed in two installments. The first installment, called the advance, covers up to 85% of the invoice. The advance is deposited in your bank account soon after you submit the invoice to the factor.
The remaining 15%, less the factor’s fee, is deposited in your account after your customer pays the invoice in full. Your customer can pay on their usual terms. Although an advance of 85% is common, industries like trucking and staffing often qualify for higher advances. This amount is determined on a case-by-case basis.
Factors offer two types of factoring, commonly called “recourse factoring” and “non-recourse factoring.” Each option has its advantages and disadvantages.
3. Recourse vs. non-recourse factoring
The only difference between recourse and non-recourse factoring is how they handle a customer’s non-payment. In a recourse transaction, if your customer does not pay the invoice, you have repay the factor. You can either return the advance (plus fees) or replace the old invoice with a new one.
In a non-recourse factoring transaction, if the customer does not pay for an approved reason, you do not have to repay the factoring company. Each factor has its set of approved reasons. In most cases, your client must be bankrupt or must have closed its doors.
Keep in mind that invoice disputes are not covered by non-recourse contracts. If your client has a problem with your product or services, you have to fix the situation. Ultimately, if your customer does not pay the invoice, you have to repay the factoring company.
Most companies assume that non-recourse factoring is better than recourse factoring. This assumption is not always true. Most factoring companies are good at ensuring they buy only high-quality invoices. There is little – if any – chance that they will purchase an invoice from a company with bad credit. Thus, the chances of ever using the non-recourse component are slim. Non-recourse factors tend to also have slightly higher fees. However, non-recourse factoring can protect you against unexpected closures or client bankruptcies.
To learn more, read “Recourse vs Non-recourse factoring.”
4. How much does factoring cost?
Factoring rates are determined by the dollar amount of your invoices, the total volume of invoices, your industry, and the creditworthiness of your clients. Factoring is a competitive industry and most companies offer a monthly rate between 1.15% and 3.5%. The rate is usually prorated for shorter term periods. For example a 1.5% monthly rate could be quoted and prorated as 0.5% per ten days.
Companies that want to factor very small amounts, usually under $10,000, may get rates above 3.5%. Additionally, rates for medical factoring and construction factoring are often higher due to risk and workload.
To learn more, read “Typical factoring rates.”
5. What to look for in a factoring company
The marketplace is full of factoring companies of all sizes and levels of experience. From a client’s perspective, it can be difficult to find and select the right company. Fortunately, you can evaluate a factoring company effectively by asking them the following nine questions:
a) What type of factoring do they offer?
Most factoring companies specialize in offering recourse or non-recourse factoring. Some offer both. As mentioned before, don’t rule out one type of factoring until you clearly understand what it offers and at what cost.
b) What industries do they work with?
Most factoring companies claim that they can work in most industries. This claim is somewhat true. However, the best factoring companies tend to specialize in a few industries. Consequently, they are familiar with many large customers and their payment habits. You will do best if you work with a factor that knows your industry well. This point is very important since each industry is different. Many factors work only in certain industries like trucking, staffing, or oilfield services.
You can determine if a factor is familiar with your industry by simply asking them. Examine their answers carefully and look for important industry-specific details. If you decide to work with the factor, ask them to provide client references. Most factors will be happy to do so during the proposal stage. Obviously, the client references should be for companies in your industry.
c) How long have they been in business?
This question is one of the most important ones you can ask the factor. The best factoring companies, with few exceptions, have been around for longer than a decade. This longevity means that they have the long-term experience necessary to manage accounts during different economic circumstances (e.g., recessions, pandemics, etc.). If you think about it, it is difficult to be the good at something while you are also new at it.
d) What advance rates do you offer?
Advance rates can range from 70% to 95%, depending on your company and industry. The most common advance rate is 80% to 85%. Companies in the transportation and staffing industries may qualify for advance rates in the range of 90% to 95%. Most companies in the construction industry get 70%-80% due to the financial risks of the industry.
To learn more, read “What is the factoring advance?”
e) What factoring rates do you offer?
A factoring company should be able to give you a price estimate after you provide it with some basic information. On average, factoring rates range from 1.15% to 3.5% per 30 days. Prices below 1.15% are usually for terms less than 30 days, or they may have other undisclosed costs.
Unfortunately, some factoring companies advertise their prices in a way that makes it difficult to determine the cost of the service. Be careful of extremely cheap rates, as they may have hidden costs attached.
f) Do you have minimums?
In factoring, a “minimum” is the amount that you need to factor every period (month, quarter, or year). If your factoring company charges a minimum and you factor less than that – you must pay the difference.
Some factoring companies offer plans with “no-minimums,” while others have minimums. Factoring minimums are not necessarily bad. You can use minimums as a negotiating tool to get a much lower rate. However, set a minimum low enough to ensure you are always above it.
g) How quickly can they set up the account?
Most factoring companies can set up an account for you in 3 to 5 business days. Larger accounts may take a few more days because of the additional due diligence. Unless you need the money urgently, account setup time should not be an important consideration when you examine factoring companies.
h) Do they offer good service?
All factoring companies advertise that they offer the best service. Everybody says this, and it means very little at face value. The only way to determine if a factor offers good service is to ask them for client references in your industry. Take the time to interview the references carefully.
i) How are they funded?
How your factor is funded is crucial for the health of your business. Factors that are poorly funded may have to stop financing your invoices unexpectedly or cut your credit line. This has happened to a number of companies, especially during recessions. The best factoring companies are able to finance a portion of their invoices using their own earnings. Good factors usually have a bank line of credit, a refactoring line, or funds from private individuals.
6. How to find the best factoring company
The best way to select a factoring company is to go through this process. This worksheet (download it) will help you with the process:
a) Select and interview the candidates
Collect the names of three or four factoring companies and ask questions based on the information provided in the previous section. Do not interview more than three or four companies at a time – you can become overwhelmed easily.
Continue interviewing companies in groups of four until you have two companies that are a good match for you. Remember – keep control of the numbers. Never interview more than four companies at a time.
Note: Keep in mind that we offer factoring services as well and would like the opportunity to earn your business.
b) Start the application process
Most factoring companies have similar application processes. Depending on the size of your business, you need to provide some information about yourself and your company. You also need to provide an Invoice Aging Report.
In some cases, you may need to provide other reports such as a Profit and Loss Statement and a Balance Sheet. Unless your situation is complex, a good factoring company should be able to provide a proposal within one business day.
c) Compare their terms to determine the best deal
Although factoring proposals can be similar, they usually have important differences. Rate structures, advances, terms, recourse vs. non-recourse will all vary. Some proposals will vary in ways that make it hard to do a simple comparison. Let me illustrate with an example, using simple numbers:
- Factor A provides a 70% advance rate at a 3% 30-day rate
- Factor B provides an 80% advance rate at a 3.43% 30-day rate
Which one costs more per dollar of financing received? On a per-dollar basis, both proposals cost the same. Evaluating proposed rates on a per-dollar basis is important when comparing proposals. With this information, you can determine the best receivables factoring company to meet your specific funding needs.
To learn more, read “How to compare factoring companies.”
d) Make the decision
Once you make the decision, the factor issues its legal documents. You need to get them signed and, in some cases, notarized. This process can take a couple of days, though it may take longer in special circumstances (if your transaction is complex).
7. What happens after you choose a factor?
The last step in the process is the “first funding,” in which the factoring company provides your first advance. The process varies by company, but in general it goes as follows:
- You submit all invoices to the factor.
- Each of your customers receives a Notice of Assignment.
- Your invoices are verified.
- The funds are advanced to your account. In most cases, the funds are sent using an ACH or a wire transfer.
Can we earn your business?
We can provide factoring lines with high advances at low rates. For more information, get an online factoring quote or call (877) 300 3258.
Disclaimer: This article is for informational purposes only. Looking for a factoring company and applying for factoring services is a complex matter. Seek legal and financial advice.