Factoring

First off, what is factoring?

Factoring is any method to receive advanced funding before your receivables are paid. For example, let's say you perform a $20,000.00 surgery but you know you may not be paid for 90 days as insurance and the patient argue over their policy and their proportionate responsibility.

But, if you know that your chances of payment are high, you can do two things:

1. you could borrow against the $20,000.00 to get some money up front now; or

2. you could "sell" the $20,000.00 for a discount now.

The first scenario is traditional recourse factoring and the second scenario is non-recourse factoring, which are discussed more fully below.

Why else would you want to use Factoring?

Asset protection.

By getting your Accounts Receivable "out" of your business and into the factoring company, you can avoid the business owning a large amount of accounts receivables if the business is sued. The cash received by the business could have a lien placed against it by the factoring company to protect it, as well as the cash could be distributed out as salary and other distributions.

For professionals, an Accounts Receivable LLC may be a good opportunity to allow non-professional spouses, children, or other investors to get involved in a professional practice. Each dollar that can get "out" of the risk-generating company (the practice) into a company that generates relatively small risks (the accounts receivable company), is a dollar that is much more protected than if you did nothing. There may be income tax efficiencies as well, assuming that the children's tax brackets are lower than the professional, and assuming the "kiddie" tax is not applicable.

In other words, you can be flexible and use an outside factoring company (of which numerous options and a competitive market exists), or you can form your own factoring company / Accounts Receivable, LLC to provide these services. This way you don't really "give up" any of the income and you gain large amounts of protection.

Recourse versus Non-Recourse Factoring

Recourse

Recourse factoring is what most people think of when they hear the word "factoring". This involves a third-party factoring company (either a true third party, or a third-party business also owned by you or friendly owners) lending on a short-term basis for your accounts receivable. Here's how it roughly works in Texas:

1. Your business generates a $20,000.00 invoice that you know will be paid in about 60 days.

2. You need cash now or you wish to asset protect the invoice.

3. You send the invoice and any supporting paperwork to the factor.

4. Within 24-72 hours the factor lends a percentage of the invoice, usually 80%, holding 20% in reserve. So you receive $16,000.00 within a few days of sending the invoice.

5. The factor charges a factoring fee of approximately 0.1% per day (3% per 30 days or 6% per 60 days). Since we'll be paid in 60 days, our factoring fee will be 6% times $20,000.00 = $1,200.00.¹

6. At day 60, the client pays the factoring company the invoice, and the factoring company pays the remaining 20% reserve to your business, less the $1,200.00 factoring fee.

7. This means you collected $16,000.00 in 3 days or less, and an additional $2,800 in 60 days.

The $1,200.00 factoring fee would count as an expense towards your business. From an asset protection standpoint, the factoring compay would file what is known as a UCC Financing statement to put a lien on your business's personal property, meaning that if the factoring company isn't paid, then it can foreclose your businesses bank accounts. This is advantageous because it makes your business look like a poor target for litigation, even if you are also owner or part owner of the factoring company.

However, if you use an outside factoring company that you don't control, and if an invoice isn't paid, you'll owe the factoring company the amount of the money advanced, as well as the factoring fee until paid. This is the "recourse" portion of the factoring. Typically, since your business will have numerous invoices outstanding with your factor, the factor will first use your available reserve from all of your theoretically "good" invoices to pay the deficiency, typically after 90 days elapse from invoice date. Once your reserve is exhausted and new invoices remain unpaid, the factor may begin collections against your business.

Important

Full recourse factoring is basically a Texas specific strategy as many states either prohibit the practice or consider the factoring fee as interest subject to state usury laws.

Non-Recourse

Non-recourse financing is where the factor has no recourse against your business if your customer fails to pay the invoice. However, be careful to read your factoring agreements as many 'no-recourse' agreement are actually just a modified recourse agreement where the no-recourse only kicks in if the customer declares bankruptcy.

I also tend to lump in outright sales of accounts receivables into this category although factoring companies do exist that still follow a cash-advance pattern of a recourse factoring company. There are companies that will outright purchase your accounts receivables for pennies on the dollar and assume all of the collections risk. If you also control the accounts receivable purchase, you're not truly losing receiving pennies on the dollar, you're shifting assets out of the risky business into the low-risk accounts receivable company.

Footnotes