Suzanne Brooker and Stacey Jones, of Pitmans LLP, explain these alternative funding methods for businesses.
Factoring and invoice discounting provide an alternative funding option to businesses, either as a stand-alone facility, or as part of a wider, more traditional facility, such as a term loan and/or overdraft.
Essentially, the lender lends against a proportion of the value of unpaid invoices, and in certain cases, this can even extend to unbilled work in progress.
What do the two processes involve?
Both methods generally involve the following steps.
The company and the financier agree:
- the terms of the factoring or invoice discounting arrangement, including the amount to be advanced by the financier against each invoice
- the terms of recourse (being the circumstances where an invoice is rejected/returned to the business)
- the amount of credit notes permitted
- whether the facility is confidential or not
- the rate of interest chargeable on the daily outstanding balance
- the amount of the facility fees (including, but not limited to, any termination fee)
- The company sells goods or services to its customers and raises an invoice.
- The financier makes cash immediately available to the company, typically around 75-85% of the value of the invoice, in return for an absolute assignment of the benefit of the invoice (and its proceeds).
- The financier receives the invoice amount either directly from the debtor, or indirectly through the company (on a confidential basis), and deducts an amount equal to the cash paid to the company, as well as the interest payable and the fixed fee.
- The financier pays the remaining balance back to the company.
What is the difference between factoring and invoice discounting?
The main difference between factoring and invoice discounting is the way in which the debts are collected from the customer.
Factoring: the financier will assume responsibility for collecting the money due under the invoice directly from the customer. This may be beneficial to the company, because it will not need to waste resources chasing the customer for payment, and provides a form of outsourced credit control. However, the company will have no control over the way in which the financier chooses to pursue payment from the customer, or the preservation of the relationship between the customer and the company.
In practice, the lender does seek the assistance of the company in collecting debts as part of the wider lender/borrower relationship. Factoring is not a confidential process, as the customer will be made aware of the existence of the financing arrangement.
Invoice discounting: conversely, this process often involves the company retaining responsibility for collecting the debt from the customer and paying the invoice amount to the financier. Although the company will still have to incur the expense and time in pursuing payment, it will at least be able to preserve its relationship or reputation with its customers. Invoice discounting can therefore be a confidential process, as the company will not be obliged to notify the customer of the existence of the financing arrangement.
Are these processes suitable for my company?
Factoring and invoice discounting can provide essential cash flow smoothing in the interim period between the sale of goods and/or services and payment.
Factoring and invoice discounting are common forms of ‘quasi-security’, whereby the financier secures repayment of the money advanced to the company by effectively acquiring ownership of the company’s book debts (its unpaid invoices). The company will not, therefore, be able to give security over those unpaid invoices to any other lender or financier.
Quite often, such arrangements are also secured by the taking of wider security over the assets of the company (by way of debenture creating fixed and floating charges over the assets in favour of the lender) and personal guarantees (usually limited in amount) from the directors. Additional warranties from the directors regarding fraudulent activity are expected.
What do lenders need to consider?
There is a code of best practice in existence within the industry that sets out the core criteria to be considered by lenders. The costs of a factoring or invoice discounting facility vary, as does the amount of the facility. Each are considered on the basis of the probity of the debts following an audit, and in light of the business undertaken by the borrower and its contracts with its customers. Interest rates and fees are provided on a case by case basis, and are representative of the amount of the facility, the type of the business and the risk.
The industry is very competitive and is now regarded as one that offers flexibility based on trading activity, rather than as being only used by companies that have cash flow issues.