Factoring 101 Challenge #5: Learning Types and Styles of Factoring

Factoring is one of the oldest known forms of commercial finance and though it has grown steadily through the centuries, its basic structure and list of services is still very similar to those found in transactions referenced during the Middle Ages.  Over the centuries, factors have created many transactional programs to accommodate particular customer types an industries.  Today, factoring programs and specialty areas are expansive and nearly as numerous as the factors themselves.  Still, the nuts and bolts basics of accounts receivable factoring always remain the same and these can be divided into just two major styles;  Maturity Factoring and Advance Factoring.

Maturity Style Factoring

Maturity Factoring has its historical roots imbedded firmly in the garment and textile industries and has been common in America since the 1920’s.  It is known by a variety of other names such as Traditional Factoring or Old Line Factoring.

All true maturity factoring arrangements are primarily structured around the factor’s provision of credit and collection services rather than that of actually advancing of cash for financing.  In a standard maturity style  factoring transaction:

• The factor provides credit analysis of a client’s customer or group of customers.
• If the invoices are not paid within terms by the customer after delivery, for example 30 days, the factor then pays the owed amount upon credit approved accounts.

If a credit approved customer is unable to pay an invoice due to insolvency or bankruptcy, the factor provides payment to the client as guarantor.

There are no “advances” of cash made under a true maturity factoring arrangement.  Payment is only made to the client at the average maturity of the invoice batch if the purchased accounts remain unpaid.

As mentioned, maturity factoring is historically related to the garment and textile industries where it is still routinely found.  In fact, some aspects of modern maturity factoring in America are easily traced back to the Colonial era of “king cotton”.  Because of the massive, and ever growing, amounts of offshore manufacturing now prevalent in this industry, true maturity factoring arrangements are no longer as common as they once were.  In fact, recent polls of the industry reveal that well under twenty percent (20%) of all factors now offer a maturity-styled factoring product.

Advance Style Factoring (California Factoring)

Since maturity factors historically purchased and had control over a client’s accounts receivable, a natural and eventual service addition to the maturity style was to provide some form of “pre-payment” or terms of payment finance option upon the invoices purchased, rather than just traditional credit analysis and collection services.  Such requests were already occurring on occasion in the maturity factoring arena and enough in fact, for some creative California-based factors to style a completely new type of factoring transaction based upon an immediate advance of cash rather than just credit and collection services.

Initially, this California factoring, most often called advance factoring, focused on industries other than garments and textiles and created a powerful new and accessible form of small business finance which was now available to cash-starved entrepreneurs nationwide.  Unlike maturity factoring arrangements where the factor was a guarantor of invoice payment and  client was expected to wait 30-60 days before payment was received or not received, the new advance factors tended to put their clients on almost a C.O.D. basis.  Advance factoring was initially directed towards smaller clients, typically those business owners generating under $150,000 in sales each month and since this was a business segment largely ignored by the nation’s large maturity factors.

Once the advance factoring transaction was perfected, this new factoring style grew exponentially.  Today, the advance style of factoring represents a strong majority of all transactions and an ever growing segment of the asset-based finance industry.

The Growth of Advance Factoring

As the prevalence and popularity of the modern advance-style of factoring grew, hundreds of industry types and segments were added to the range of prospective factoring clients.  It’s now safe to say that the days of factoring services being primarily associated with the garment and textile industries have likely ended forever.

In a standard advance-styled factoring transaction today:

• The factor advances funds on purchased accounts immediately when goods are delivered or services rendered to the customer.  Cash for the purchased accounts are wired directly into the client’s business bank account.
• The factor still provides expert credit analysis and collection services for the client’s benefit.

Recourse and Non-Recourse Factoring

One of the questions most often asked by prospective clients is:  “What happens if one of my customers doesn’t pay? “ The answer depends on the kind of factoring facility or arrangement set up or requested by the client.  Was it one of recourse or non-recourse.

As you already know, traditional or maturity factoring factoring was a service that strictly provided credit analysis and collections regarding customers and their invoices, rather than financing.  The factor paid the face value of invoices ONLY if the customer failed to pay within the allotted time under the terms of payment granted.  Since the factor is the guarantor in a maturity factoring arrangement, all such arrangements are non-recourse by definition, meaning the factor has no other option to pay the client if the customer’s invoice is unpaid due to insolvency or bankruptcy.  The factor takes the loss and pays the client.

In modern advance factoring arrangements, factors can provide their services either on a recourse or on a non-recourse basis.  Under a non-recourse method, the factor will be responsible for the losses on credit-accepted accounts which are not paid by the customer based on the insolvency or bankruptcy measure.  Under a recourse method, however, the client is said to “warrant” the payment of the invoice to the factor by the customer.  If the purchased invoice goes uncollected after a stipulated period of time (usually 90 days), the factor will charge back, forcing the repurchase of the failed invoice to the client’s account.

Its important to note that California-style recourse factoring, is quite often employed to finance smaller client businesses with often with even smaller, marginal account debtor credits.  Non-recourse factoring simply doesn’t provide the necessary service to the client who is primarily in need of financing and immediate cash under all circumstances. Obviously, a factor is not going to agree to guarantee and purchase large amounts of invoices generated from sales to very small retailers that could realistically “close up shop” tomorrow.

So, in some cases, those small customers may be responsible for a relatively large portion of the total sales of the factor’s client.  In such instances where a client sells to a majority of small “mom and pop” businesses and establishments, the guarantees provided by non-recourse factoring are unrealistic and simply will not do the job.  Only a recourse-style transaction can provide the much needed working capital and cash flow solutions in those instances.

Notification and Non-Notification Factoring

Standard factoring agreements include a notification clause which allows the factor to notice customers that when making payment under their normal terms, they now have the obligation to make payment to the factor and no longer to the client.  Notification guidelines are set forth in the UCC and typically state that…

“once notified, the account debtor’s obligation of payment is now to the notifier and no longer to the client”.

Though rare, factoring is available under a non-notification agreement but which greatly increases the risk to the factor or asset-based lender.  Since customers are not notified regarding the need to make payments directly to the factor, this exposes the factor to theft by the client (being paid twice on the same invoice). It exposes the factor to losses and legal expenses as it tries to recoup its invoice payment.

When terms are granted for non-notification factoring, the factor will require that….

• all payment to be directed to a lock-box at a bank of the factor’s choice and also require that all invoices bear only the address of the lock-box for remittance and…
• the client’s books to be audited (usually quarterly) to ascertain whether any invoices have been collected upon and the funds circumvented from the factor’s lock-box.

In any case, where non-notification is granted, the client’s credit will be important.  While traditional factoring is available to even the newest businesses regardless of years in operation, non-notification factoring requires a very well established, creditworthy business and owner.