As with any booming industry, the activity in the oil and gas business creates both opportunities and challenges for entrepreneurs and small companies. Many service providers are struggling with the financial demands of their expanding workload; meeting payroll, the costs of materials and rental equipment, etc. can cause acute problems, particularly for a smaller business. Without an available financing source to support growth opportunities, business owners may be forced to turn down work. Who is willing to lend to these companies? Unfortunately, traditional banks don’t seem to be responding to the call. The answer may be a form of secured lending known as factoring: working capital advances based on a company’s accounts receivable.
A factoring company provides financing to its clients by using their unpaid invoices as collateral. It typically works like this: the client “sells” its receivables to the factor, which will then advance 80-90% of the face value of the accounts. These advances are usually available very quickly – normally within 24 hours of acceptance and verification by the factor. The result: more reliable cash flow and an acceleration of the company’s cash flow cycle by 45-60 days, or however long it would otherwise take to to collect the receivables. As sales grow, so does borrowing availability, because the factoring facility is tied directly to account receivable. Typically, there is no “bank loan committee” review process. Factors are also more lenient when it comes to financial reporting and personal credit issues. This kind of flexible, aggressive funding can be a real shot in the arm to a small company, helping not only to relieve cash flow stress, but also to increase production capacity.
How do they do it?
The answer lies in the structured “sale” or “assignment” of receivables by the company to the factor. The factor is able to lend aggressively to their client because they have literally bought the collateral. The factor has the legal right to notify the customer (or “account debtor”) to pay directly to the factor. This structure allows the factor to rely on the financial strength and creditworthiness of the customer – which is frequently a larger, well established company – rather than the client, which may be small and undercapitalized, or even an unproven start up.
More Aggressive lending
Thanks to this collateral-driven approach, the factor can lend more as sales and receivables grow, and usually without the delay or interruption typical in the bank review process. It’s not unusual for a small business owner to be able to leverage his investment by ten-to-one or more using advances from the factor. That can be a game-changer for a small company faced with growth opportunities. In our business, we have seen companies who were growing at a 10-20% annual pace suddenly boost growth to 100% or more. The profits generated by this growth in sales more than covers the cost of factor financing.
To protect its collateral, the factor does credit checking, collection, cash posting, and bookkeeping. The client benefits from all of these back office functions. Effectively the factor becomes an outsourced credit/collection department. This allows the business owner to focus on sales and production and reduce administrative costs. Pretty slick, huh?
So, what’s the catch?
The factor’s active management of the accounts implies a need to communicate with those customers to verify and collect invoices. If you decide to factor your invoices, it’s not going to be a secret to your customers. Is this a bad thing? Not really. Larger companies know what factoring is. Chances are quite a few of their vendors and service providers are already factoring, so they know the drill. Verification, validating the accounts submitted for funding (is the work or product delivery completed? Are the pricing and terms correct?), can be done by an experienced factoring company without being intrusive. And contact with the A/P department for collection purposes by a factor instead of an office assistant is preferred, because the factoring agents should be professional and efficient.
Other common myths about factoring:
Myth #1 – If you are factoring, you must be in financial trouble.
Any business owner who has paid a visit to his community bank loan officer knows how difficult it is to get adequate bank financing. Factors have filled the gap. This has become such a common occurrence that this myth has become a dated cliché. It never made much sense. What lender wants to lose money lending to a company that’s falling off the cliff? A good factor wants his client to be a viable business with a reasonable chance of success.
Myth #2 – All factoring companies are the same.
There are literally hundreds of factoring companies out there, and all are different. Some focus on specific industries. Some are bank-owned. The size of the factoring company is very important: larger factors tend to be more stable and professional, but they could also be more rigid and less service oriented. Smaller factors generally have a better service reputation, but are the staff knowledgeable? As with any product/service, it’s important to know who you are dealing with. The best way is to insist on references. Even as the factor is doing its due diligence in the application process, you need to do yours.
Myth #3 – Factoring is expensive.
Unlike banks who charge an interest rate, factors generally charge a discount of between 2-4% on each invoice financed (the actual rate is contractual and is generally based on volume). Yes, banks are cheaper. But if they aren’t lending, is it really a fair comparison? Alternatives may include investors looking for a large chunk of ownership. Now that’s expensive. Factoring can be cost effective if you consider the additional sales volume (and related profits) that would otherwise be lost without the financing. And don’t forget that the service aspect of factoring – the management of credit and collections – that are included in the cost of financing. For growth companies in particular, factoring costs are a smart investment.
Myth #4 – My customers are not going to like this.
Do you know what they like less? Small companies that ask them to pay cash on delivery, or request deposits before starting a project, or hound them for shortened credit terms. Factoring allows the client the ability to extend normal industry credit terms to its customers. Those customers also benefit from the increased production capacity provided by the financing.
Some clients worry that the factor’s need to communicate may chafe certain customers. A good factor will not overstress your customers. And here again, the factor provides some services that benefit those customers at no cost to them. The factor will assist in making sure that your billing procedures conform to your customers’ standards, for instance. The factor’s communication with your customers assures integrity in the billing process. Your more sophisticated customers will understand that benefit.
Myth #5 – Factoring will hurt my credit rating.
Generally, the opposite is true. Having available financing means vendors get paid on time which makes credit managers happy. Many of our clients proudly tell new vendors they have a factoring facility to provide consistent cash flow. In most cases, a company that factors its receivables benefits not only from the financing provided, but also by the expansion of vendor credit lines. Free vendor credit is a very good thing.
Myth #6 – My business does not sell a tangible product, so factoring can’t benefit me.
Factoring works for goods or services. The key qualifier is whether there are verifiable business-to-business accounts receivable. Labor service companies are actually an excellent fit for factoring, since the advances allow companies to meet weekly payroll needs despite customers that pay in sixty days.
Michael Miller is a senior executive at Transfac Capital Inc which has been providing financing for small-to-medium sized companies since 1942. For more information, contact Amanda Brinton at (385)212-3950 or firstname.lastname@example.org. www.transfac.com