Most prospective clients consider the factoring rate the most important feature of a plan. In fact, pricing is usually the first question clients ask prospective finance companies. Seeking the best rate is a good strategy, but it should not be the only detail you look for. Other parts of a plan are just as important. This article covers the following:
- How significant are rate differences?
- Find and evaluate factoring companies
- Compare factoring proposals effectively
- Conclusion
1. How significant are rate differences?
Factoring companies have several ways to price their services. However, the cost often involves a percentage that increases with time. A common industry approach is to use percentage cost for a defined block of time. Usually, it’s in the format of “X% per number of days.”
Let’s look at the actual cost impact of different rates. Assume a company does $100,000 in monthly sales and has customers who pay in 30 days. The management team of this company has to compare the following proposals to determine which is better:
- 2% per 30 days
- 2.25% per 30 days
Most people would immediately think that the first offer is substantially better. However, is this really the case? The dollar difference amounts to only $250 per $100,000 factored per month. Here is an explanation:
| Invoice Amount | Factoring Rate | Cost |
|---|---|---|
| $100,000 | 2.25% | $2,250 |
| $100,000 | 2.00% | $2,000 |
| Difference | $250 |
For a company invoicing $100,000 per month on net-30 terms, this difference can amount to $3,000 per year ($250 x 12 = $3,000). However, consider that this company is making $1,200,000 per year ($100,000 x 12 = $1,200,000). In this context, $3,000 represents a small portion of annual revenues. Should the rate be the only driver of the choice of factoring company?
The rate is definitely an important part of what a factoring company offers. However, you should also evaluate other aspects of your potential finance partner.
Note: This example has been simplified for clarity.
2. How to evaluate factoring companies
A better strategy is to look for the most cost-effective factoring company that meets all your needs. Don’t focus only on price, as this may mislead you. Instead, examine the whole picture and work with the company that best fits your company and growth strategy.
Create a list of factoring companies that you will evaluate. You can develop this list by using the Internet, asking colleagues, and speaking to your advisers. Once you have developed a list, take the factoring companies through the following set of questions.
a) How long have they been in the industry?
The factoring industry has many companies with only a few years of experience. This may not be an issue if the factor has a seasoned management team. However, you are usually better off working with a company that has been in the industry for a while. A finance company with some longevity usually has experience managing client portfolios through different economic environments.
b) Do they have clients in your industry?
Most factoring companies claim to be generalists that can work in any industry. However, they will focus on getting clients in a few industries only. It is important to work with a factoring company that has clients in your industry. This background ensures they have industry knowledge. This knowledge is essential for clients in specialized industries, such as trucking and construction.
c) Do they work with companies your size?
Factoring companies often state they can work with companies of any size. They can handle small businesses and large companies alike. While this claim may be true, most factors specialize in companies of a certain size. You are better off if your company is not the factor’s largest or smallest client.
d) What are the factoring and advance rates?
Ask them about their factoring rates, structure, and advances for companies in your industry and size class. This information enables you to calculate the cost per dollar of the service. Using a cost-per-dollar approach allows you to compare factoring proposals. We cover this topic in the next section.
e) Are their contract terms acceptable?
Ask them to explain their contract terms. Contract terms include the length (e.g., monthly, yearly), whether they have minimums, etc. Are you comfortable with these terms?
f) Can they provide references?
Ask the factoring company to provide you with a list of references. The list should have companies that are in your industry and are of similar size to yours. Contact these references to evaluate how the factor manages its clients. Speaking with these references is essential, as it is the only way you can get information about how the factor treats clients.
3. How to compare factoring proposals?
The next step is to examine your list and select the top two or three factoring companies. Ask them to provide a proposal so you can make the final selection.
a) Compare rates
Factoring proposals usually quote a financing rate, an advance rate, and a time frame. These variables can make comparing factoring rates somewhat challenging. For example, which option offers the better price:
- 70% advance, 3% per 30 days?
- 80% advance, 3.35% per 30 days?
| Advance | Factoring Rate | Cost Per Dollar |
|---|---|---|
| 70% | 3.00% (30 days) | $0.043 per dollar |
| 80% | 3.35% (30 days) | $0.043 per dollar |
A way to simplify this analysis is to compare the cost per dollar of each proposal. You can do this by using equal timeframes while dividing the financing rate by the advance. This calculation gives you an approximate cost per dollar for the time period. In the above example, both options have a similar cost per dollar $0.043 (4.3 cents). Use the first option if your company can live with a 70% advance. If you need a higher advance, use the second option.
b) Compare terms
Compare each factoring company using the questions you asked in Section 2. Determine which company is a better fit for your requirements.
c) Other items
Create a list of other things you noticed while you interviewed the factoring company. This list should cover items that were not on the evaluation list. Examples include:
- Which factor appeared to be a better fit?
- Was their staff professional?
- Does the company seem well-run?
4. Conclusion
The decision to use invoice factoring to finance your business should be strategic. Focusing your search for a provider by comparing factoring rates may help you find the finance company offering the lowest cost. However, it won’t necessarily get you the right finance company for your business. Evaluate potential partners carefully so you can find the best partner to help you reach your objective.
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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.