For ISOs Only — How To Develop Your Factoring Brokerage Business (Part 2)
In Part 2, we’re going to focus on 3 major areas:
(1) What is Factoring and How Does it Work?
(2) What Are the Costs?
(3) How Do You Qualify?
We’re also going to touch on HOW TO find factoring funders.
What is Factoring and How Does it Work?
Factoring actually dates back to 2000 BC but got going in the US during the 1600s when colonists sought “advance payments” on tobacco, cotton, etc., shipped across the Atlantic to England. Today, it’s a TRILLION DOLLAR INDUSTRY worldwide, involving commercial banks, asset-based lenders, Fintech companies, and private hedge funds all over the world. And a million years later the purpose of factoring is the same; speed up cash flow by leveraging receivables, while waiting to get paid.
In a nutshell, much like an MCA, factoring is an advance against “future invoice proceeds.”
However, unlike an MCA where the advance is largely based on bank statements, with factoring, advances are based on the number of confirmed invoices the merchant has outstanding with their approved B2B customers. The invoice(s), which is the asset, serves as COLLATERAL.
So, while an MCA funder “looks backwards” at bank statements to help determine eligible amount, the factoring funder “looks forward” to determine eligible amount based on approved invoices.
Factoring advance rates typically range from 70% to 90% of the invoice face value, and are based on volume, industry type, etc.
There are two major elements required for factoring to work. The first is the merchant must be doing business with a credit-worthy B2B customer. Approval isn’t based on the financial strength of the merchant, but on their customer, i.e. the company paying the bill.
The second major element is that, in addition to being credit-worthy, the customer must agree to send invoice payments DIRECTLY to the funder. This provides the funder with an assurance of payment and substantially reduces the risk of re-payment or default.
So, unlike an MCA where payment is on a daily or weekly basis, the factoring advance has NO PAYMENTS, and actually pays itself off once the invoice has been paid. The funder then deducts the advance along with their fee and wires the balance to the merchant.
With no payments and invoice proceeds automatically paying off the advance, I refer to this as a “SELF LIQUIDATING LOAN”. It’s also “ELASTIC”, which means the more confirmed invoices the merchant has outstanding, the more funding they are eligible to draw. It’s like having a revolving LOC with no payments………of course unless the customer doesn’t pay, right? Good question!
So, here’s the answer: There’s actually two types of factoring; (1) RECOURSE FACTORING, which means if a customer doesn’t pay the invoice, the Merchant is financially responsible for the advance, and (2) NON-RECOURSE FACTORING, which means they’re not.
Here’s the process in a nutshell: Merchant submits app and doc checklist for preliminary underwriting approval. Funder issues term sheet, and if accepted by Merchant, underwriting and due diligence is completed. A closing and funding docs package are submitted to the merchant, and upon execution, the funder is prepared to start confirming and funding invoices.
How long does it take from start to finish? Depends on how much hair there is on the file. A clean file can take as little as 5 to 7 business days. A file with a lot of hair can take much longer. We actually had a $13 million file funded in 48 hours! That guy was pretty happy and so was I. It was an acquisition with a deadline. So, here’s what to tell your merchants with regards to timing: “funding is not calendar-related, but event related”. In other words, once the required events are completed then funding can occur.”
What Are the Costs?
There are several major factors that determine cost, rate, terms. volume, invoice size and funding frequency, industry type, risk, etc. Every funder has their own respective rate and fee schedule. Some charge application/due diligence fees while others don’t. Some charge origination and/or admin fees, while others don’t.
Some funders base their pricing on APR, with rates as low as Prime + 3 to 5%, while others have all-in rates typically ranging from 1.5% to 3% per month. After the first 30 days, monthly rates are typically broken down in 10 or 15 day increments (pro-rating). As a result, the ACTUAL COST of factoring in dollars and cents, is based on the amount of time the advance is outstanding, from the funding date to the date the invoice payment is received by the funder.
Here’s an alternative perspective on cost: Factoring is like “renting money on a daily basis,” where the funder essentially takes “equity in the transaction” versus equity in the business. Comparing the bottom-line cost with the bottom-line benefits is the key. But at the end of the day, “the highest price you pay for money is the price you pay for the LACK of it”.
Just like with MCAs, make sure you understand the rate structure, terms, and fees charged by your factoring funder, and how to calculate the cost in dollars and cents as well.
How Do You Qualify?
Factoring approvals have 3 components: The first is the merchant. Again, every funder has their own approval criteria and document checklist. Some require minimal info, while others ask for EVERYTHING including a pint of blood. While most only require one month bank, approval is not based on deposits, or how well they manage their account. Remember their primary focus is on assessing the quality of the receivables, determining if they have sufficient gross profit margins, ensure they are in good standing, and address any “deal killers”, i.e. tax liens, judgments, or UCC filings in first position, which is where they need to be, in most cases. (We actually have funding partners who will factor in second and third positions)
The second factoring approval is the merchant’s customer(s), typically referred to as the debtor. This is determined by the funder who looks at things like D&B, PAYDEX Scores, and other proprietary industry databases. In some instances, a lack of secondary financial/credit information on the customer can be offset through their payment history with the merchant. In other instances, the funder may require bank and trade references if no history exists. Candidly speaking, best practices by the merchant says they should already be doing the same thing; i.e. credit qualifying their customers, whether they need funding or not, unless it’s a large, well established company or government agency. The fact is, extending terms to someone you don’t know can be risky because ‘all businesses may not be good businesses.’ Let’s face it, it’s all about getting paid, right?
Ever heard this horror story; “I need an MCA because I got burned by one of my customers who strung me out and never paid me!” Too bad. They should have picked up that $100 bill off the street! Just kidding!
The third factoring approval is on the deal itself, i.e. the purchase order or contract the merchant has with the debtor. There are over 15 different things the funder will look at to identify existing or potential funding issues. Here’s an example. I recently got a referral for a client who had 63 different purchase orders going to 63 different locations for the same large customer, but BEFORE he started shipping, half the orders had already passed the CANCELLATION DATE! What do you think the chances are of the deal being approved for funding? Don’t know yet. Will let you know when I get to part 3 of the series. Keep your fingers crossed and so will I.
Typical things the funder looks at are payment terms, default clauses, customer signature, offset clauses, just to name a few. If you’d like a complete list, just shoot me over an email.
How to Find Funders
Finding factoring funders is easy. Just google FACTORING and you’ll get a whole bunch. What’s NOT so easy is determining the “best fit” for YOUR merchant because one size does not fit all. Over the years, some of the biggest horror stories I’ve heard from both funders and clients was a relationship that went bad because it was not the best fit. But remember this; “just because you picked the wrong spouse doesn’t mean getting married is a bad idea.” Determining the best fit is one of the key functions for your factoring brokerage business.
Some funders you will find specialize by industry, i.e. transportation, medical, staffing, construction, while others don’t. Some can move quickly while others take two weeks. Some are more flexible than others. Some focus on A-credit Merchants and have the lower rates, while others work with start-ups. Always find out UPFRONT their approval criteria and constraints. Shoot over an email and I’ll send our list of the Top 10 Questions to Ask Before Selecting a Factoring Funder.Last modified: January 9, 2020
Gerald C Watson is a Financial Intermediary specializing in arranging Contract and Working Capital Financing for growing firms throughout the country, for over the past 20 years.
Gerald has spoken on numerous panels and conducted seminars on Contract Financing within the public and private sector, written numerous articles and published a workbook on Contract Financing, and provided testimony on the subject of Contract Financing before the United States Commission on Minority Business in Washington, DC.
He has served on numerous Board of Directors, including the Commercial Finance Association (CFA), the St John's River Community College, and has also been a recipient of the SBA Business Advocate of the Year Award, and is a member of the International Factoring Association (IFA).
Gerald holds a Bachelor of Science in Business Administration from Babson College in Wellesley, Massachusetts, and a Master of Science in Business from the Management Education Institute in Cambridge, Massachusetts, where he graduated third in his class with Honors. Connect with him on LinkedIn or email him here