Factoring: A Working
Capital Solution

Although interest rates may be at an all-time low, many companies in mid -to-low-margin businesses cannot leverage sufficient working capital using traditional lending sources. As customers are demanding longer billing cycles, and suppliers are unwilling to extend the same, emerging market players are unable to position themselves to scale sales volumes without sufficient cash flow. As a consequence, otherwise healthy businesses with strong long-term revenue projections are faced with a dilemma of short-term cash shortage.

One way to address this issue is through accounts receivable factoring. Originating from the New York garment industry during the early part of the 20th century, accounts receivable factoring has become an acceptable form of cash procurement in the business marketplace. Essentially, the transaction can be structured in on of two ways. Factors that are commercial lenders may be able to avoid state usury laws and therefore lend directly against receivables. Another way to structure the transaction is to treat the account receivables like a transferable piece of personal property (the legal term in this case is chattel paper), which can bought and sold as a commodity. The sale element makes this transaction different from a loan, and therefore state usury laws would likely be inapplicable. Further, Article 9 of the Uniform Commercial Code generally governs these transactions, but each state has its different statutory nuances with respect to secured filings and the like.

There are two types of transactions, one being "Full-Recourse," the other "Non-Recourse." Full Recourse will require the business owner to buy back the account, "Non-Recourse" will not. In the event that the Seller's customer, the "account debtor," fails to pay, then the Seller bears the risk of buying back the account, paying back the Facto and still be responsible for the Factor's fees. Additionally, you can expect that a Seller may be asked to pledge personal collateral and sign a personal guarantee for payment. This collateral will tend to be subject to a secured filing form UCC-1 statement, basically giving the Factor priority over unsecured creditors if the Factor doesn't get paid. Keep in mind that most Factors cherry pick good accounts receivables by checking out the credit history of ones' customers and ability to pay. The credit-worthiness of ones' customers is a key ingredient in assessing risk for the Factor.

The mechanics of the transaction can be relatively simple. The Factor will buy a Seller's book (or portion thereof) of accounts receivables for a short period (usually 30-90 days), pay a purchase price (usually 65%-80%) of the face value and retain the remainder as a reserve. A portion of this payment is used to pay off the Seller's vendors upon delivery and possibly take advantage of early payment discounts that can offset some of the factoring costs; the remainder is left for the Seller's immediate use towards operations. When the account becomes due, the account debtor will pay the face value of the account receivable directly to the Factor. Upon receipt of payment, the Factor will deduct their fees and expenses and release the remaining amounts in reserve to the Seller.

Normally a Factor's fees run approximately 1%-3% of the face value of the account every ten (10) days the debt remains unpaid. If you start to add up a sixty day billing cycle, the fees can run as high as 18%. Although this may seem a high rate, the lower the risk to the Factor, the more you can negotiate the rate. Additionally, one may look at the rate as the cost for the opportunity and Factors can typically start funding your receivables much faster than a bank would be able to extend you a line of credit.
Nonetheless, potential clients should be encouraged to shop around to find a Factor with a reputation for delivery, ancillary resources, excellent customer service, and the ability to work within your particular business needs.

Finally, factoring may not be the appropriate cash flow solution for every business, but it may provide sufficient working capital to some business seeking to exploit immediate opportunities in the marketplace.

David Michail is a business, corporate, and commercial transactions attorney in Los Angeles, California. This article is intended for informational purposes only, and shall not be construed as rendering legal advice and establishing an attorney-client relationship. For more information, you may contact Mr. Michail at 310-670-4656 or visit his web site at www.michaillaw.com.