Marsh Business Advisors, LLC
"CAPITAL"
When A Bank Loan Is Not An Option, Try Factoring
By: Stuart Wm. Marsh
President, Genesee Capital, Inc.
July 14, 1995
Good news for entrepreneurs and business owners in Rochester!
Not only is there a new source of financing now available, but also a new type of financing.
Many entrepreneurs and owners of young businesses have gone the traditional route of seeking financing from a bank, only to discover that their company isn't old enough, or isn't profitable enough, or doesn't have enough collateral, or, worse, all three.
Discouraged, the entrepreneur approaches various government entities in search of capital, only to discover that his or her company is too risky to be funded by taxpayers.
Dejected, the entrepreneur works up the courage to talk to venture capitalists, only to find that, while it doesn't matter that the company is too young, not profitable enough, lacking collateral and very risky, the return the venture capitalist is seeking is extremely high. Worse, the venture money may be precisely the wrong type of capital needed.
A young company's cash needs often are very short term. There's been some blip in the cash flow, and the bills still need to be paid. What to do?
One potential solution: factoring.
Factoring involves the outright sale of a company's accounts receivable to a third party called a factor. The factor purchases the accounts receivable from the company for cash, assumes all the credit risk of the receivable, and also assumes the time risk; that is, the length of time that elapses until the receivable ultimately is collected.
Factoring has been around for a very long time, but up until about 10 years ago it was confined primarily (in this country) to the garment industry. Makers of fashion apparel were far more interested in designing and manufacturing clothes and selling them to retailers than they were in checking the creditworthiness of their customers and managing the accounts-receivable collection process.
For some reason, factoring has connotations of "risky'' and "expensive.''
But "expensive'' is a relative term. Whenever something is characterized as expensive, the first question that should be asked is: expensive compared to what?
French champagne is expensive compared to California champagnes. Cuban cigars are expensive compared to Honduran cigars. A Mercedes-Benz is expensive compared to a Cadillac.
French champagne is more expensive because there is only one Champagne region, with its ideal grape-growing conditions, in the entire world. Cuban cigars are more expensive because Cuba has virtually the finest tobacco-growing conditions in the world. A Mercedes-Benz is more expensive because, well, because it's a Mercedes-Benz.
Just as all champagne is not the same, all cigars are not the same, all cars are not the same and all money is not the same. Some money is more expensive than other money.
The price or cost of money is not determined by the underlying "product.'' Money is a pure commodity: Every U.S. dollar is worth every other U.S. dollar. The price of a dollar instead is determined by the risk associated with the use of that dollar.
Factoring is more expensive than bank borrowings. So, given the choice, the wise entrepreneur will borrow from a bank. But factoring and bank debt are rarely the two competing alternatives. If borrowing from a bank isn't an option, factoring should be considered.
Richard Champion, president of Dominion Capital Corp., a new factoring company based in Rochester, told me there were many instances in which factoring should be considered when bank debt is not an option. Rick should know; he founded Dominion Capital after more than 20 years of corporate-credit-analysis and commercial-lending experience, most recently as senior vice president of Fleet Bank of New York.
Rick outlined some situations in which factoring should be considered:
~ a start-up company with no track record;
~ a company considering the sale of equity;
~ a company that has experienced periodic losses;
~ a company that is forgoing discounts due to a lack of cash;
~ a company that has been put on credit hold by suppliers;
~ a service company whose only tangible assets are its accounts receivable; and
~ a company in a seasonal industry with historically slow receivable collections.
A bank lends money to a company based upon the creditworthiness of the company. A factor purchases accounts receivable from a company based upon the creditworthiness of the accounts receivable.
The following example shows how the factoring process works:
Company C sells a metric ton of new and improved Grade-AAA extra-fine phlogiston to Company AR for $10,000. The invoice issued to Company AR is for $10,000 with payment expected within 30 days; but if paid within five days, AR may take a 2 percent discount.
From experience, Company C knows that AR probably will not take advantage of the discount, and will make payment on the invoice somewhere between 45 and 60 days.
Before payment is collected from Company AR, Company C needs to pay its employees, and pay for overhead and materials. These parties frankly don't care whether Company C is experiencing cash-flow problems with its receivable collections: They want to be paid.
Company C needs cash, and with the laughter of the banker rejecting the loan request still ringing in the president's ears, Company C's owner meets with a factor.
Factor F agrees to purchase the account receivable of Company AR from Company C. The factor is comfortable with the creditworthiness of Company AR, and in this case establishes an advance rate of 75 percent and a 30-day discount of 3 percent.
Factor F advances Company C $7,500 (75 percent of the $10,000 receivable), and sets up the balance of $2,500 as a reserve against returns and discounts, as well as to cover the eventual fee earned.
On day 30, Company AR remits payment in full of the $10,000 invoice to Factor F: the new owner of the invoice. Factor F keeps $7,500, which was the amount advanced to Company C. Factor F deducts $300, which represents the 3 percent discount, and then rebates the balance of $2,200 to Company C.
In this case, the factor earned $300 and the company received a total of $9,700 in cash, of which $7,500 was advanced immediately upon the sale of the receivable to the factor, and $2,200 was received upon collection of the invoice.
Now let's assume that instead of making payment on day 30, Company AR pays the invoice on day 60. In this case, Company C still would receive the $7,500 advance immediately upon the sale of the receivable. However, on day 60, when the $10,000 payment on the invoice is made, Factor F would keep the $7,500 advance and deduct $600, which represents the 30-day discount of 3 percent for two 30-day periods, then rebate the balance of $1,900 to Company C.
If Company AR ultimately made payment on day 90, the discount earned by the factor would be $900, representing three 30-day periods.
The astute mathematical mind would instantly leap to the following conclusion: A discount of 3 percent a month would mean an effective interest rate of 36 percent a year!
The astute mathematical mind would instantly be wrong.
If the company had the use of $10,000 for one month, and paid $300 at the end of the month for the use of that $10,000, then the effective interest rate would be 36 percent a year.
But the company had use of only $7,500 for one month, and paid $300 at the end of the month for the use of that $7,500. So the effective interest rate would be 48 percent a year.
Ouch! That's just about what "vulture'' capitalists are looking to earn on their money. (In our socialist economy, I'm surprised there isn't a law against this sort of thing!)
Wait a minute. Whenever we think about buying something, we always look at its cost. But isn't there another decision-making process going on simultaneously? Don't we also look at value?
We may decide to buy Cuban cigars, even though they're more expensive, because they're better cigars and may even cement that business relationship. We may decide to buy French champagne, even though it's more expensive, because it's a better champagne and might help cement that personal relationship (if you know what I mean). We may decide to buy a Mercedes-Benz, even though it's more expensive, because it's a better car and maybe projects an image we like.
The decision to employ the services of a factor is not based upon the alternative of borrowing money from a bank: If that option existed, it would be chosen.
The decision to use a factor usually is based upon the need to solve a short- term cash-flow problem, or take advantage of an opportunity that requires cash.
In the above example, what should the business owner do if the company has enough cash to meet payroll and operating expenses, and the materials don't have to be paid for until the receivable is collected? Obviously, it would be foolish to use a factor.
What if the material suppliers offered a significant discount for a cash prepayment? What if the landlord offered a significant discount for a cash prepayment? The answer hinges on whether the discounts earned are higher than the cost of factoring.
Since cash is king, a savvy business person, with cash, can create a lot of opportunities. Factoring is a method by which a company's assets can be converted into cash.
Factoring will continue to grow as a source of financing, and like all financial products can meet a certain need at a certain point in a company's life.
Factoring is more expensive than some financing means but not as expensive as others.
Factoring creates cash for your business. If you don't think that's a benefit, just remember the Golden Rule of Business: He who has the gold, makes the rules.