Simple is good. The fewer working parts there are the less likely something can go wrong. Simple is easier to understand, figure out and fix. When it comes to financing a business, nothing is simpler than Factoring.
When a small business owner (the Seller) factors an invoice from a customer (the Debtor) it is sold to a Factor (the Buyer) who then owns the debt. The Seller replaces an Account Receivable with Cash and they are free to spend it as they wish. The Debtor on the other hand pays the Factor directly under the terms that were originally agreed upon.
It gets more complicated when you learn that the Factor has no greater right to payment from the Debtor than the Seller. In other words, if the Debtor does not receive or is not happy with the product or service then even the Factor won’t be able to collect. It’s this reason that Factoring is riskier than most people think.
Like every form of business finance there are variations and variables for every situation. Normally a portion of the purchase amount is held back in the form of a Reserve to cover nonpayment, chargebacks, and shortages. Only once an invoice has been paid does the Factor release the Reserve. Reserves are usually 20% of the invoice but I’ve seen them range from 50 to 3%.
Factors use other tools to help lower risk for themselves which end up benefiting everyone. They set appropriate credit limits for each Debtor, examine every invoice and the supporting backup for accuracy and they pay close attention to the outstanding invoices. Daily reports are provided, communication is encouraged, and it becomes in everyone’s best interest to make sure that invoices are paid timely.
A proper Factoring program creates a classic Win-Win-Win scenario. The business owner gets the cash, the customer gets open account terms and the factor earns a fee for making it all happen. It should also comfort business owners to know that the more successful they are the better everyone who supports them does as well. Isn’t that the true definition of relationship-based financing?