Written by : Lori Karpman
Small business today generally refers to business generating under $3 million in annual sales. That's not so small to most people. And a big business was small business at one time. The challenge is "how do you get there from here"? The financing community is about to get some real financial assistance-and its called Factoring. Traditionally, start-ups use the small business loan as seed capital, and his still remains the ideal, lowest risk choice. Once up and running however, the issues of cash flow become the day to day issues that determine the financial stability and future potential of the company.
The present financing options available to serve these purposes are (1) traditional bank financing, and 2 additional private investment. Each of these options achieves the goal of providing funds to your business but as is always true, there are associated costs. Bank financing has the nasty side effect of burdening your business with additional debt, not only capital repayment but additional debt by way of interest. If the goal is to fund growth, taking on additional on additional debt certainly takes a chunk out of the disposable funds available to finance that growth and effects the financial position of the company for years to come. The application process is long and cumbersome. The delay between the tie of submission of the application to disbursement is substantial as well, putting extra constraints on the timing of your financing needs. And...what if you may not be creditworthy, many have used your available credit limit, or be in violation of debt/equity ratios.
The other common route is private investment. In these cases, the injection of capital is given in return for an equity interest in the business. There are a variety of forms this can take but suffice it to say, that the end result is a dilution of your equity in the company that you have built. While often a great choice for large corporations, the effects are more widely operated businesses. Diluting equity, or granting an ownership interest to an outside partly generally waters down the value of all shares and creates a situation where one shareholder has a preferred status and priority in payment over the decision making processes depending on the clout of private investor and the amount on money invested. These are serious hidden costs.
So, what now? You can't go to the bank because you are credit limit and you don't want a private investor, but you just got this huge $10 million dollar deal and you need to build a warehouse. Well, there's a new financial here to the rescue and its name is "Factoring". To say it's new is really a mistake since it has been around since the days of the Roman Empire. The United States factors 50 times as many transactions as Canada and over $1 trillion in sales in factored worldwide annually. In the United States, many banks even have factoring divisions. Some scandals in the United States have left factoring with undeserved tarnished reputation. In fact, it is a champion of small business and an essential tool in the arsenal of financing options.
Factoring involves the sale of accounts receivable at a discount. Essentially, you sell the receivables that are to you by your customers to a “Factor"/ who discounts the value of them and pays you in advance. The discount depends on many factors but is generally between 3-6% for a pre-negotiated period of time and a fraction of that thereafter. In essence you are raising funds not on the basis of your creditworthiness but that of your customers. So you may not be able to get credit but as long as your customers are creditworthy you can leverage that to raise funds for your own business. For example, you have not created the extra burden of debt, nor have you diluted your equity.
Yes, you have taken a hit up-front, but, the money did not come out of your pocket and is a cost of doing business. The important thing is that it allowed you to fulfill your main goal of getting financing in a timely manner and being able to take advantage of a growth opportunity that would have otherwise evaded you. The same line of reasoning works for seasonal businesses that need to maintain a continual cash flow to fund operations. This is a great tool for that! Now, I must confess that I came upon this discovery because I have client in this field, but sincerely (and morally), this little known source of financing was like a secret that was too good not to share.
The legalities of this financing are equally as simple. If bank financing is in place then all that is required is that bank give up its first ranking security on the receivable being factored. The bank is generally amenable to as it still has security on everything else. The factor then takes the place of the bank on that receivable and takes security much in the same the bank would. Furthermore, because there no interest charges no your money, none of the banking legislation is applicable, making the entire transaction simpler all around. The charges you pay are discount fees, the cost of having your money now and avoiding all the burdens of the other methods of financing. Second mortgage anyone?
I think what you will find most surprising is that factoring is highly endorsed by financial professionals, including banks. It makes a lot of sense though that they should. Business clients have many needs ad professionals, be it lawyers; accountants or bankers need to respond to them. Banks like that it keeps their client financially afloat when they cannot help them. Small and medium businesses often fail because of short term cash flow problems, not because business is bad!
Traditional bank financing and private investment can never be replaced. They are the cornerstones of corporate fiancé. The problem is getting to the point where you can truly benefit from their value. Small business to medium, and medium to large, factoring is fulfilling an untapped niche in the financial industry. While it takes a lot of (paper) work away from us lawyers, I am still all for it. I guess the secret's out of the bag!