The Cost
of Account Receivable Factoring
Guess
what...account receivable factoring is expensive. The good news?
It doesn't have to be as pricey as you might have heard it is.
Invoice Percentage Fee
The
invoice fee will range from 2% of the invoice
amount (very very rare) to 10% of the invoice amount (also very
very rare, thank goodness.) Most account receivable factoring costs
between 2.5% and 5% of the invoice amount for invoices that are
paid in 30 to 45 days. You can find lower fees…and you can
certainly get quoted higher fees. (By the way, the fee is often
called the "discount rate" or the "invoice discount
rate".) In the section on selecting from among the invoice
factoring companies we'll suggest a good process (that doesn't take
much time) to get the right price for you.
Is
that too expensive?
The
answer to that question is actually pretty simple: if you need the
cash flow to avoid turning down new business, and your margins are
reasonable, account receivable factoring may well be worth it. Here's
a simple example: let's say you get that call of your dreams: a
customer wants to give you an order for $75,000. You pencil it out,
and you can make a 20% gross margin, dropping an extra $15,000 to
your bottom line to help cover all your fixed costs, etc. That's
good money. But, the problem is that this customer won't pay you
until 60 days after they receive your invoice, while you have to
pay your vendors (or employees) quickly. So, you turn down the order,
and say goodbye to that $15,000 bottom line contribution.
On
the other hand, if you were using receivables factoring, you would
have paid, say, 5% to the factoring company (that's $3,750 in the
example above), received the cash, paid your vendors (or employees)
and pocketed $11,250 as the contribution to your bottom line when
your customer sent in their check to the lockbox of the factor.
You
should do the math for your own business.
If
you need help, you can use our factoring
receivables calculator. Account receivable factoring companies
will also tell you they save you in costs of administration, collection,
credit checking, etc., so we've included those in the calculator
above, but don't kid yourself: the big benefit of factoring receivables
is the fact that you don't turn down business because of lack of
cash flow.
Also,
please keep one thing in mind: In the vast majority of cases, rates
are based on the invoice amount, rather than the advance amount
(see the section below called "Advance Rate" for the definition
of this). Nobody likes "paying for money they don't receive",
but you'll have to suck it up and do this with most receivables
factoring companies. We'll show you how to clearly ask about this
aspect of the fees in the section on choosing an invoice factoring
company.
Advance
Rate
In
the section on how invoice factoring works we explain that after
you submit your invoice and it is confirmed, you'll receive 70%
to 85% of the invoice amount from your receivables factoring company.
That percentage is called the "Advance Rate" or the "Advance
Percentage." All other things being equal, the higher the better,
for two reasons:
- First,
you might need the extra cash to pay your vendors and employees.
This may or may not be true for your business. If your margins
are over 25% (based on subtracting your material costs or direct
labor costs from the purchase price) then the Advance Rate is
less important, because in most cases you'll get enough to pay
your vendors. Even if you are a tad short just on a percentage
basis, you'll find that once you start factoring receivables,
you'll have quite a bit of cash on hand.
- Second,
a high advance rate is good because the fee you pay your receivables
factoring company is based on the invoice amount…not the
amount advanced to you. Here's the math on this: let's say you
are quoted a fee (often called the invoice discount rate or just
discount rate) of 3% of the invoice amount. If one receivables
factoring company quotes you a 75% advance rate, and another one
quotes you an 80% advance rate, then your actual cost for funds
advanced is 3%/75% for the first receivables factoring company
(which is 4.0% of the funds advanced) and 3%/80% for the other
factoring company (which is 3.75% of the funds advanced).
So,
if the primary importance of the advance rate for you is its impact
on price (the second example above), then all you have to do is
get quoted the fee and advance rate, do the math, and calculate
your "net" price. If the advance rate is also important
because you need a certain minimum to make your business work (the
first example above), then you might decide to pay a higher "net"
price on funds advanced to get the advance rate you really need.
Other
Fees
Yes,
you too can get charged "other" fees by your account receivable
factoring company. In fact, this is almost a given.
So,
the best strategy for you is to make sure you know about them up
front. Here are the most common ones:
Application
Fee and/or Setup Fee: Here's the scenario you don't want:
- You pay
a receivables factoring company a non-refundable application fee.
- You apply.
- They turn
you down.
- They do
not refund the fee.
If
somebody presents you with that little idea, please just say "no
thank you" and put down the phone. While it is true that they
do incur costs for processing your application, it is unreasonable
to expect you to pay something for nothing. Some will make the application
fee refundable if they turn you down. That's better, but not ideal
because they might just quote you such a high rate that it isn't
worth it for you.
The
next best scenario is a set-up fee instead of an application fee.
The receivables factoring company might tell you that once they
approve you, you need to pay a set-up fee (typically $100 to $500,
though they can go higher) before you start processing invoices.
The
ideal scenario, of course, is no application fee or set-up fee at
all.
The
set-up fee probably won't be the "make or break" element
of the overall pricing. Instead, the best part about "no setup
fee" is that it suggests the factoring company has enough confidence
in their services that you'll keep using them after the first couple
of invoices, so they can earn enough to reimburse them for their
start-up costs.
Annual
Fee or Monthly Fee or Audit Fee: Some account receivable factoring
companies will charge you a "maintenance" fee of sorts,
either annually, semi-annually, quarterly, or monthly. The idea
is that if you don't use them as much as they had hoped, they have
some way to make back their costs.
If
you are using your account receivable factoring company quite a
bit, chances are this fee won't make a big difference in the overall
price. If you decide to use them less than you thought, then this
fee makes a bigger difference.
You
can do the math based on your expectations of usage. Just like with
the set-up fee, the best part about a "no maintenance fee"
arrangement is that it suggests the account receivable factoring
company has confidence that you'll like their services enough to
use them a lot.
Low
Volume Fee or Below Minimum Fee or Minimum Contract Dollar Volume
or Length: Yes, some account receivable factoring companies
will charge you if you factor less invoice dollar volume than you
said you would. Sometimes, this fee can be really high, so be careful.
The
receivables factoring company will say "Look, we quoted you
a price based on the volume you said you'd do, so we have to make
it back somehow." Your best response is "True, but that
was an estimate on my part. I really don't know how much volume
I'll do. I'd rather you charge me a higher price and then not charge
me if I go below a minimum volume." Then, compare the quotes
you get back.
Other
Per Transaction Fees: Here are some of the ones we've seen:
A per-check fee, charged for each check received at the lockbox.
A per-wire fee, charged each time you receive a funds advance for
your invoices. A per-invoice fee, charged as a fixed dollar amount
per invoice, in addition to the percentage fee per invoice. And,
there are others out there also. We promise.
The
best thing to do is to verify that any quote you receive includes
all possible fees. In the section on choosing among invoice factoring
companies we'll suggest a way to do this.
Other
Bad-Things-Happening Fees: In every account receivable factoring
contract, there are clauses about your responsibility for legal
fees, collection costs, etc., which you will incur if you breach
your contract with them. In some contracts, there are also steep
penalties if you receive a check from your customer and then cash
it, instead of sending the check to the lockbox of the account receivable
factoring company.
Such
fees are a fact of life in the world of account receivable factoring.
Most
of the time, these fees are not delineated specifically. Your best
bet is to understand your obligations and responsibilities under
the contract, and then keep your side of the bargain. If you don't,
well, prepare to see your profits vanish.
Recourse
(OR, What happens when my customer doesn't pay?)
Want
some entertainment? Try to decipher the following contract text:
8.
Repurchase Of Accounts. Purchaser may require that Seller repurchase,
by payment of the then unpaid Face Amount thereof together with
any unpaid fees relating to the Purchased Account on demand: 8.1.
Notwithstanding Insolvency. Notwithstanding the occurrence of an
Insolvency Event: 8.1.1. Any Purchased Account: 8.1.1.1. The payment
of which has been disputed by the Account Debtor obligated thereon,
Purchaser being under no obligation to determine the bona fides
of such dispute; 8.1.1.2. For which Seller has breached its warranty
as set forth in Section 14.4 hereof. 8.1.2. All Purchased Accounts
upon the occurrence of an Event of Default, or upon the termination
date of this Agreement; and 8.2. Absent Insolvency. If an Insolvency
Event has not occurred on or prior to the Late Payment Date, any
Purchased Account which remains unpaid beyond the Late Payment Date.
What
does it mean?
Well,
in this case it means that if your customer does not pay your invoice
within 120 days (which was the "Late Payment Date" defined
in this sample contract), you are required to pay back the amount
that was originally advanced to you, plus late fees. There are some
exceptions to this rule, but you shouldn't count on them.
Account
receivable factoring companies will tell you that they are "No
Recourse" which should mean that if your customer doesn't pay,
you are not responsible to return the funds advanced to you. But,
the contracts typically have so many exceptions in the fine print,
that in most cases you really are responsible to return the funds.
For example, if your customer says "I was unhappy with the
quality of the products/services delivered", then you are responsible.
If your customer takes too long to pay, sometimes you are responsible.
There are definitely some contracts that will protect you if your
customer declares bankruptcy within 2-3 months of your invoice date
(which is the case with the contract sample above) but, let's face
it, how likely is THAT?
Your
best bet is to go into an account receivable factoring program with
the assumption that if your customer doesn't pay, you will have
to return the funds advanced to you. If in some cases you don't
have to, then be pleasantly surprised.
Personal
Guarantee
Wait…you
may say. Why should I as the owner have to guarantee the performance
of my business? It should stand on its own, especially because I'm
incorporated.
Guess
again. If your business accepts credit cards, one of the owners
has issued a personal guarantee. If your business leases something,
one of the owners has probably issued a personal guarantee. And,
if your business is factoring receivables, chances are extraordinarily
high that an owner has issued a personal guarantee.
But
wait, you may say, I have entered into a "Non Recourse"
arrangement, so my business will never really "owe" money
if my customers don't pay, hence I won't ever be personally liable.
If
you believe this, then please see the section above called "Recourse".
But
wait, you may say, I'm absolutely positive that there is nothing
in my contract that says an owner is personally liable.
Ah,
but even if there is nothing in the contract that says so, you might
still be. Sound unfair? Well the fact is that in cases of fraud,
it is legal for an account receivable factoring company to "pierce
the corporate veil" and go after the owners personally, whether
or not they signed a personal guarantee. And, you should know that
fraud can be pretty broadly defined in an account receivable factoring
contract. For example, accidentally depositing a check that should
have gone to the lockbox can be considered fraud.
So
what's the bottom line? What should I do?
Your
best bet is to mentally pretend that you are personally responsible
if one of your customers does not pay. That way you won't be disappointed
or surprised. Then, in selecting your account receivable factoring
company, focus on the financial terms and their process.
Please
review the other parts of this website to learn more about this:
How
does invoice factoring work? What is the process, and what
will my customers experience?
What is the best way to select
a factoring company? How do I avoid the time consuming process
of winnowing through all the factoring companies out there, yet
still get the best terms for my business?
How
do I know if I'll qualify for a factoring service? How do
I avoid spending a lot of time on complicated applications only
to find out that nobody will help me?
"Please
note: if you came to this site by searching for the word(s) Factoring
Companies, Invoice
Factoring, Factoring
Service you
can click on any of those words to go to the home page of this site
to see a definition."
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