Tread carefully if you think debt factoring will improve your business cash flow.
Choose the wrong facility and you could blow a big hole in your bottom line.
What may work for your mate’s business, or the one down the road, may not work for you.
The biggest danger is to be f00led by a sexy headline rate. Many business owners are and become blind to the time bombs hidden in the fine print.
A client of mine was recently contacted by a competitor offering him just such a pyrotechnic.
He was completely sucked in by the cheap rate.
The client sent me a copy of the offer. He made it clear that we would be parting ways unless I matched or bettered the apparent lower price.
It put me in a difficult position.
Our fee reflected the risk involved in dealing with this client. It also reflected our high service standards. I wasn’t going to devalue either.
Neither did I want to bag a competitor even when I could see the offer was wrong for my client.
So, I decided the best thing to do was lay out the case for each facility and let him decide.
To begin with our competitor required that my client sign a 12-month contract and enter into a “full service” agreement.
That meant the finance company would take control of my client’s debtors’ ledger.
All invoices issued by my client would provide security for any funds advanced by the financier.
The financier would also provide accounts receivable management, reminder letters, monthly statements, cash allocation and telephone collection activities.
Now, some businesses don’t like handing this sort of control to a finance company, but others love it because it reduces their workload and provides certainty. The business owner knows working capital will always be available each month come what may.
It works particularly well when a business has lumpy cash flow, but lots of customers and strong earnings.
My client’s business was nowhere near there yet.
It had a handful of customers. Some paid early, some paid late. In some months, he needed working capital, in others he didn’t.
The new agreement required he finance all invoices whether he needed funds or not.
Even if a customer paid immediately, the finance company would charge a fee. He couldn’t afford that.
We charged only for invoices the client sold to us. It was up to him to decide when he needed funds.
There were also big differences in the fee structures of both products,
We charged one fee determined by the amount of the invoice and how long it took to get paid.
The cost ranged between 3% and 5% of the invoice amount over 30 days.
We were more expensive than our competitor’s sexy headline rate, but we offered greater flexibility.
We also provided quick decision making and a highly individualized service. That’s worth something.
Our client also retained control of his debtors’ ledger.
Our competitor promoted an attractive headline rate of 2.5%. It applied to all invoices issued by the client each month.
But there was a minimum monthly charge of $1,500 plus GST. The client would have to pay that whether he had the invoices to factor or not.
That’s $18,000 a year.
There was also:
A $2,500 application fee
An annual interest rate of 11.75% charged on monies advanced.
An account keeping fee charged on every transaction.
An exit fee.
All “full-service” debt factoring providers have these kinds of fees. It’s their way of recovering the cost of setting up and managing an account which may have dozens and even hundreds of debtors. For the most part, the fees are reasonable.
The one fee I do find unreasonable is the exit fee.
The government banned home loan lenders from charging exit fees.
Not so, invoice finance companies most of whom will charge an exit fee if you decide to end a contract early.
You can be forced to pay thousands of dollars.
In our case, there is no contract. so, there is no exit fee. Clients can come and go as they please. It’s up to them.
Our competitor also required 90 days notice to break a contract.
This can be a dangerous trap. Financiers will often reduce the amount they fund during the notice period.
Sometimes they won’t fund any invoices at all. This can leave the business owner stuck without cash flow for up to three months.
It would have broken my client.
There were other important items not discussed in the offer.
There was no mention of debtor concentration.
You should always ask about this and how it will work before signing an agreement.
Let’s say you have a credit facility a $500,000 a month and you have 20 customers. The financier will advance up to 80% of that ($400,000).
If you lose a couple of big customers your debtor concentration has increased. The finance company will reduce the funds available to you because there is now a greater risk.
In the worst case, if you fall below the debtor concentration limit, it may give you nothing at all.
This can throw your growth plans, or even your survival plans, into chaos.
We’re a bit different. We don’t have debtor concentration limits. We’ll provide 80% funding on a single debtor.
Our competitor also reserved the right to decline invoices.
That’s ok. We do the same.
The difference is that we won’t charge for invoices we’ve declined.
Under the terms of the full service agreement, our competitor would charge a fee.
Debt factoring is a great tool for managing business cash flow and enabling growth.