Factoring finance and invoice discounting are increasingly important sources of funding for SMEs and many businesses are finding that their banks are forcing them away from overdraft funding and in this direction. But they are forms of finance with dangers for the unwary and this article covers how these forms of finance work, the issues to look out for and how to choose an appropriate funder.
Both invoice discounting and factoring allow you to raise money against your outstanding debtors by in effect ‘selling’ the invoices to the lender who will advance you a nominal 65% to 85% of the approved invoices immediately. But as the lender takes over the debtors as security, these are not then available as security for a bank overdraft. Completion of an invoice finance deal therefore usually involves paying off any existing overdraft out of the initial advance received against your debtor book.
In factoring, the lender takes over management of your sales ledger and actively chases in payment, which can in itself be an advantage if your credit control has been poor. In some cases factors will allow a CHOCs arrangement for key accounts (client handles own customers) whereby you retain control of the contact with the customer, and some have also developed confidential factoring.
Invoice discounting is usually only available to businesses with turnovers greater than £1m and a relatively strong balance sheet. It differs from factoring in that you continue to run your own sales ledger and collect in your own debtors. As you are continuing to do the work, it is therefore possible to have a confidential invoice discounting arrangement (CID) which means that your customers will not be aware of the arrangement.
Some invoice discounters can take finished goods stock into account and can then offer higher levels of advance (sometimes exceeding 100% of your debtor book).
Up until the start of the credit crunch, this had been a rapidly expanding market and there are still therefore a wide variety of lenders falling into three main categories.
There are the clearing bank owned firms who obtain much of their work by their in-house bank referrals.
Then there are the large independents, which in practice tend to be owned by overseas banks, and who provide both factoring and invoice discounting facilities as well as now being able to provide funding packages for use in MBO/MBIs, for example covering property and plant and machinery as well as debtors.
Finally, there are a large number of smaller players, generally focused on factoring but who may well have developed particular niches such as construction debt, architects’ practices, government debt, or care homes, which can require particular expertise in lending.
So when thinking about this type of finance, some of the issues you need to consider are:
– With factoring you will lose control of how your customers are chased for payment unless you can arrange a CHOCs or confidential factoring arrangement.
– Your facility will be based on a percentage advance against approved invoices. The actual or effective advance you receive as a percentage of your total debtors can be significantly less than this nominal headline percentage, as the lender may disallow debts over three months old, sales to suppliers, overseas debts, or may set concentration limits where individual customer’s debts cannot be more than a set percentage of your sales ledger or credit limit per customer. You need to look at the nature of your debts and ensure that you will not run into such problems.
– Some debts are difficult to fund against. There are only a limited number of lenders who will deal with contractual debt involving stage payments such as construction contracts, while sales which require extensive after sales service or warranties such as bespoke computer software, may not be fundable.
– If you hold customer tools, expect some difficult conversations with funders as to whether this is a good or bad thing in respect of securing payments from customers.
– As the advance is tied directly to invoicing, invoice finance is well suited to fast growing companies as the financing automatically expands as the business grows reducing the danger of overtrading.
– However, as the facility is tied to sales volume, if sales fall, so does the funding available (which may be just the moment that you need finance the most!).
– Once you have this type of facility in place, it can be extremely difficult to get to a position where you can exit the arrangement.
– There is still a stigma attached to factoring in some circles as it has been seen as financing of last resort, however as banks have moved more and more customers to invoice based financing and this has becomes a normal part of almost every MBO/MBI transaction, the stigma is disappearing, and of course is avoided with confidential invoice discounting.
– Fees will include a cost for an initial audit which may be refunded against the normal charges if you go ahead, a take on fee for setting the facility up, and an ongoing service charge for running the facility, as well as interest on the funds borrowed. Factoring and invoice discounting are often perceived as expensive, however when comparing costs against bank facilities it is important to compare against the total cost of equivalent bank facilities including interest, management charges and so on, to reach a fair comparison. Key items issues to think about in any arrangement are:
– Contract length (usually 12 months) and any exit penalties;
– Minimum fees included which mean you carry on paying even if you do not draw down cash; and
– Extras, where there may be charges for things like TTs of funds. Some lenders appear to quote low on the basis that they will make up revenue on extras, some try and give an all in price, so ensure you are comparing like with like.
– Given that the credit control function is part of what you are paying for in a factoring deal, make sure you understand what level of service you are buying. Are all debtors going to be chased or just the top slice? How effective is the chasing? You should always take up references and ask to meet the operations team who will be handling your account since the sales person you are dealing with now will usually not be involved in the relationship going forwards.
– Finally, ask to see copies of the statements that you will receive on your account. Ensure that these are fully explained to you so that you understand how to follow them once the arrangement is up and running.
The good news is that there are over 50 factoring and invoice discounting lenders operating in the UK today so there is plenty of choice, however you should always take advice to ensure that you engage an appropriate funder and are aware of all the terms of the agreement and their implications for your business.