Factoring: How to Finance your Business without Debt or Dilution of Equity

Factoring, or “the sale of accounts receivable,” is a source of funding whereby a company sells the value of their accounts receivable (less a discount in case it doesn’t get collected or doesn’t get paid on time) to a third party in return for immediate payment.

It has always been a choice for big businesses, but not so for small to medium ones with gross sales of under $5 million per year, which really isn’t that small. The small business loan program offered by the banks is still essential for the initial startup phase, but most companies need financing during the operating stage and often cannot get it from a bank for a variety of reasons. It can be because they have already borrowed the maximum available, or additional borrowing will cause them to breach their borrowing ratios under existing loans. This makes it very difficult for businesses, especially seasonal ones, to ensure the steady cash flow required to run their business during the low periods and young companies from filling big orders.  So, what, who, and where does a business owner go to finance their growth?

Factoring is hardly new and has existed since the days of the Roman Empire. Unfortunately, some scandals in the U.S. in the younger stages of the industry left factoring with an undeserved tarnished reputation that still prevails today.  Factoring companies are not banks, however, in the US, banks may have a factoring division.  It became seen as the recourse of last resort for companies in financial distress who sent their accounts receivable to collections. In fact, none of this is true; factoring is a brilliant way to fund operations without burdening the company with debt that would take years to pay back or diluting the owner’s equity. Results don’t lie; companies that factor their receivables usually double or triple their business in 2-3 years. Over $1 trillion in sales is factored worldwide annually. In fact, factoring is the champion of small business and an essential partner in managing its financial growth. Small and medium businesses often fail because of short-term cash flow problems, not because the business idea is bad!

The two traditional financing options are (1) traditional bank financing and (2) private (equity) investment. Each of these options provides a company with much-needed working capital for daily operations and to service current orders. However, there are significant costs associated with each choice.

A traditional bank loan burdens the company with additional debt, plus the cost of the interest being paid on the debt, creating a debt far greater than the amount borrowed. Additionally, this being a loan, it shows up as debt on financial statements, making it even more difficult for a company to get a bank loan later.  All revenues coming in are being used to service debt instead of upgrading equipment or buying more inventory, for example. It’s difficult for a business saddled with debt to grow.

The other option is to seek private investors to invest money into the business and fund its operations.  The issue with private investment is that the amount of equity required to be given in return for the investment is usually substantially more than the equity is currently worth, and it will cost many times that amount to buy out that shareholder at a later date. It’s the most expensive form of financing there is. The end result is the dilution of the owner’s equity in their own company. It can even result in a complete loss and transference of control to the new investor. While this may work for a large company with many shareholders, it is generally not a good alternative for owner-operated or family-run businesses.

Simply put: Every company has “receivables” from the people it sells products or services to.  The company sells all its accounts receivables to a “factor” at a discount. The factor discounts the face value of the invoice based on a variety of factors, such as the industry and how long it generally takes to get the invoices paid. The company receives about 85% of the face value immediately and the balance less the discount fee when the account is collected. The discount amount depends on many factors but is generally between 3-6% for a pre-negotiated period of time and a fraction of that thereafter. The uniqueness of this alternative is that the business owner is not trying to borrow based on their own and the company’s creditworthiness but that of each one of the company’s customers. So, while the company may not have good credit as long as the customers do, the company can leverage and borrow against their good credit!  Most companies find that they no longer need a bookkeeper or office assistant, and the salary they save easily covers the discount fee and more.

Here’s a perfect example. Many years ago, I met a woman who had a home stereo installation business. Her clients were primarily large box electronics stores. She worked out of one equipped and retrofitted truck. She was offered a new contract, but that would require her to purchase and retrofit a new truck at a cost of $75,000 and hire someone to work it.  he did not have funds for this investment. What she did have was a $100,000 receivable from a national electronics chain with great credit. She factored her $100,000 receivable in return for $85,000 cash which was paid in 24 hours. She then went out and made her purchases and accepted a very lucrative new opportunity. She continues to factor all her receivables today. Within two years of her original factoring, she tripled her business, all without creating debt or giving up control. It’s important to note that the Discount Fee is an expense, not interest, and is treated as such in financial statements. After three years passed, she was easily able to get a traditional loan to expand her business further, as she had no debt. Factoring her receivables was the single smartest decision she made for the growth of her business.

When you factor your accounts receivable, you no longer have the stress of wondering when the next cheque will come in; you will have a steady cash flow, even as a seasonal business. Generally, businesses grow exponentially as the owner is now freed up to work “ON” the business and not “in” it.  From that comes great new revenue-generating ideas and the time required to make them a reality. Owners are relieved not to have to worry about finances and collections. In fact, financial professionals and bankers are big proponents of factoring as it keeps their clients in business when they cannot.

If you are still worried about the stigma, don’t be your customers will never know a thing!  If your company sells a product/service that generates accounts receivable, then you have a hidden treasure of financing for your business and owe it to yourself to learn more about it.

Lori Karpman, CEO Lori Karpman is president of Lori Karpman & Company, A full
service firm providing a full range of consulting and legal services.

www.lorikarpman.com

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