Factoring 101: What is Factoring?
If you’re looking at possible funding options for your business you may be considering factoring as a solution. This cash flow management tool can be used when other funding opportunities aren’t an option. While this method of financing can provide cash immediately there are a few risks you may want to know about. Keep reading to learn more.
What it Is
The process of factoring is when a business sells its accounts receivable to a financing company. The business receives funding and the financing company collects any pending payments. This method is often used for financing when a business can’t get a traditional bank loan.
This process may sound similar to invoice discounting, however is differs in a key way. In a factor transaction the business is essentially selling the right to collect payment to the financing company, while in a discounting transaction the business has essentially taken out a loan against future income and then must pay back that loan.
There are a few risks associated with factoring that you may want to be aware of. First, it is an unregulated industry meaning you will want to thoroughly research any company before selling your accounts receivable to them. Consider how long the company has been in business, what their background is, and how the company is managed when making your decision. You may also want to remain aware of the nature of your accounts receivable to ensure that you’re operating legally as certain transactions, such as selling financial security accounts, is considered fraud.
Also consider what’s in your contract. Is it negotiable? What is the term length? Many experts recommend month to month contract. You may also want to check that the fees associated with your contract are manageable for your business. It’s a good idea to watch for something like personal guarantee requirements. These mean you could be held responsible if a customer defaults.
Another aspect to keep your eye on is how your customers will be treated by the finance company. In most cases a process is in place that allows your customers to continue business with you, however in some cases the financing company will want to handle collection with their own staff. You may want to be sure your customers are treated well and your company’s reputation remains intact.
Now that you understand what factoring is and what some of the risks involved are you can begin doing your own research to determine if this is the right option for your business. Remember to make sure you’re working with a reputable company, your customers are treated well, and that you are legally allowed to sell your accounts in the first place.