Factoring Costs The 10 Most Misunderstood Cost Drivers Joe Sillay Executive Vice President Federal National Commercial Credit 7315 Wisconsin Avenue Suite 600W Bethesda, MD 20814 301.961.6450 FederalNational.com
Contents Introduction... 3 1. Invoice Factoring Rates and Fees... 4 2. Turn and Time Function of Invoice Factoring... 5 3. Advance Percentages... 7 4. Settlement Credit and Float... 9 5. Whole Turnover Invoice Factoring... 11 6. Invoice Factoring Facility Fees and Minimums... 12 7. Application Charges & Out-of-Pocket Expenses of Invoice Factoring... 14 8. Invoice Factoring Term & Renewal... 16 9. Understanding Aged Items in Invoice Factoring... 17 10. Special Services of Invoice Factoring Providers... 18 2
Introduction This outline accompanies 11 videos in a series intended to help you understand pricing common in the specialty finance industry of factoring, also known as invoice factoring, and asset based lending. Small Business Factoring and Asset Based Lending Pricing is Different than in Banking Banking is regulated In banking the way pricing is quoted is fairly standardized Bank fees, for activity in the normal course of business, don t usually produce big changes in cost This is not true with factoring and asset based lending. Everyone charges differently Fees, not rate, are very often the greatest cost driver This is Not a Demonization of Factors & Asset Based Lenders My company, Federal National Commercial Credit, is a factor and some of the features I will describe are applied by Federal National Factors and asset based lenders have different fee structures from one institution to another. The Devil is in the Details Difficult to understand what your costs will be from a verbal or even a written quote A few things are required to begin understanding the financing costs A full application package from you to the finance company A thorough, written proposal from the finance company to you based upon the package. A sample factoring agreement Time and full attention to carefully review the proposal and agreement and consider how it relates to the way your business works The assistance of your trusted advisors, such as accountant, attorney, or banker 3
Upcoming Videos 1. Fees & Rates 2. Turn and Time Function 3. Advance Percentage 4. Settlement Credit & Float 5. Whole Turnover 6. Facility & Minimums 7. Application Fees & Out Of Pocket Costs 8. Term & Renewal 9. Aged Items 10. Special Services 1. Invoice Factoring Rates and Fees Factoring rates and fees vary widely from one finance company to the next Not just in the structure and types of fee, but also in the ways the fees operate Factoring, also known as invoice factoring, & asset based lending is more labor intensive than bank lending. In most cases, these different fees are the lender s way of trying to be sure that their fees work in the same way their costs behave. Many, though not all, Factors have a Prime Plus function. Most of us are familiar with the Prime Rate index. A spread is added to the index, e.g. Prime plus 1%, 2%, 3%, etc. Less common is the use of LIBOR, the London Interbank Offered Rate, being tied to the notion of the rate charged between banks, it is lower than Prime. So the spread added is typically larger, e.g. LIBOR plus 5%, 6%, etc. The fee based on the Prime Rate or LIBOR should be an annual number and is typically charged on a daily basis. Example: If the quoted rate was Prime plus 2% and today s Prime is 3.25%, you need to add another 2% to the Prime Rate. We arrive at the annual rate of 5.25%. Divide that annual rate by 360 and you come up with the daily rate that will accrue for each day. Read the fine print: You really do need to look into just how this and other fees operate. The factoring agreement will go into this level of detail but a proposal typically will not. Service, Collateral Management, or Factoring Fees In addition to the Prime Plus fee or interest component, all invoice factoring and ABL companies charge additional fees. There is absolutely nothing standard in this category of fee. 4
Conclusion In factoring and ABL companies fees are very significant. The Servicing or Collateral Management Fees often add up to as much or more than the Prime Plus fee or interest component. There is usually more than one fee charged in an invoice factoring or asset-based lending relationship. The Prime Plus or interest component is usually not the most expensive piece. A discussion or even a proposal will not likely tell you what you need to know. You really have to thoroughly review a sample factoring or financing agreement and get out your calculator to know. Ask the proposing factor to model some examples of the fees using amounts, balances and payment turns representative of your business. Get help from your trusted advisors. 2. Turn and Time Function of Invoice Factoring Factoring Companies Advance Money against Specific Invoices The length of time invoices typically take to pay is known in finance as the Turn or Turnover of the accounts receivable Some invoices take longer to pay than others The 30 day assumption Those are likely the company s formal contract terms Finance companies often quote fees for 30 days The 30 days Quote in Invoice Factoring Proposals can be Misleading Most invoices don t really pay in 30 days. The structure of the fees and the way they perform across time is very important. The Flat Fee or Discount is charged once on each invoice and does not repeat. Your annualized rate gets lower with higher turn but the rate is usually quite high. 5
Example: A Flat Fee of 5% of the invoice amount. 5% X $100,000 invoice = a fee of $5,000 Invoice Turn 15 days 30 days 45 days 60 days Annualized % 120% 60% 40% 30% But these are very rare in today s market. A Periodic Fee for 30, 15 or 10 day periods of time. Most often at 30 days. Usually accompanied by or any part thereof language Very hard to predict your rates with accuracy because your actual invoice Turn can cause the rate to vary so greatly. Example: $100,000 invoice Periodic Fee of 2% for 30 days (or any part thereof) Invoice Turn 15 Days 30 days 31 days 60 days Fee Amount $2,000 $2,000 $4,000 $4,000 Annualized Rate 48% 24% 48% 24% The any part thereof language is sometimes justifiable in terms of the finance company s transaction cost. But look at what happens when an invoice pays in 31 days. If the average turn is 31 to 35 days, which is very common on Net 30 terms, the annual rate is more than 40%. This type of fee structure is really just making it hard for you to understand what your rate will be. There would be a similar though smaller effect if the period was 15 or 10 days rather than 30. 6
Daily Fees (usually not much to worry about here): A Prime-Based Fee is usually a daily function (refer to Video on Invoice Factoring Rates and Fees ) and is a flat daily fee. Invoice Factoring Usually Makes Use of More than One Fee Conclusion There is usually a combination of more than one of these fee types. Sometimes there are hybrids of these examples. For example, Federal National has a hybrid fee that is for the first 30 days or any part thereof then after 30 days, becomes a daily proration. We feel the first 30 days insures we cover the cost of handling an invoice transaction and changing to daily after 30 avoids arbitrarily overcharging the borrower. There is usually more than one fee charged in a factoring or asset-based lending relationship. The amount of time your invoices take to pay can cause large swings in your annualized rate. It is important to carefully understand the mechanics of each fee component and the behavior of your accounts receivable. Ask the proposing finance companies to model the way the fees will perform for different, realistic turns. Get help from your trusted advisors. 3. Advance Percentages Advance Percentages Liquidity In factoring and asset-based lending, the finance company advances a percentage of your accounts receivable. The amount they do not advance is a form of reserve to help protect them against loss and to insure coverage for their fees. Advance percentages vary but are typically from 70 to 90 percent of the invoice amount. 7
Advance percentage differences present a very significant soft cost. Most factoring and asset-based lending customers are interested in getting as much cash out of their financing as they can. So, in general, a higher advance percentage is better than a lower one. The question is, how much more do you pay for the higher advance? Fees Charged on the Face It is common practice for factoring fees, or some part of the factoring fees, to be charged on the face amount of the invoice - even though you only actually receive the advanced portion. There is a legal reason. Factoring is really the purchase of an account, not lending against the account as collateral. Charging fees on the face strengthens the legal argument that the factor purchased the accounts receivable. This can give the factor some advantages over other creditors if there is a bankruptcy. But fees charged on the face may seem lower than they really are and can make it difficult to compare the fees of different providers. Comparing Factoring Advance Percentages with the Effective Fee In order to compare the fees from one provider to those of another when fees are charged on the face amount, you have to balance out the differences in advance percentage. The best way is to compute the effective fee. The effective fee is what you pay on the money you actually receive. If you receive only 70% of the invoice amount in your advance, you want to convert to the rate that would be effective for the 70% advance. When you are working with effective fees you can compare one finance company s fees to another s even when their advance percentages are different. In the chart below, look at how the effective fee changes with advance percentage. 8
Example: A Fee of 1.5% Charge on the Face Amount of the Invoice Advance % 70% 80% 85% 90% Effective Rate 2.14% 1.87% 1.76% 1.67% Effective Fee = Quoted Fee / Advance Percentage Conclusion When fees are charged on the face amount of the invoice, advance percentage differences can produce very different effective rates. Compute the effective rate to even out advance percentage differences. Do the computations yourself or with the help of a trusted advisor such as your accountant, attorney or banker. Then ask the factoring companies to just tell you if they think your numbers are wrong and why. Remember, if the effective fees and other shopping considerations are equal, you would prefer to have the one with the higher advance percentage. 4. Settlement Credit and Float Assignment and Lockbox In factoring and asset-based lending, the finance company will take assignment of your accounts receivable. This means they notify customers that your accounts receivable have been assigned to them and should be paid to a lockbox account the finance company controls. When do you get credit and when do you get your money? Most business owners focus on the issue of the factoring company contacting their clients. But this assignment process is very routine and conventional. Most clients take it in stride without a problem. The really important questions are: Once your invoices pay into the lockbox, when do you get credit for the payment and when does the money from the payment come to your bank account? Reconcilement schedules can vary significantly between finance companies and can result in substantial differences in cost. 9
The finance company must review the payments coming into the lockbox and post the ones that belong to you to your account. This process is called reconcilement. Some finance companies reconcile every day, some once per week, some on even longer schedules. Some view it as a negotiating point. A daily reconcilement is best and the more stretched out the reconcilement frequency, the more the financing costs. This is a fine print detail typically not in proposals but buried in factoring agreements that should figure into your choice of provider. The Cost of Float Example The concept of float is the amount of time a bank or finance company takes to give you credit for an item they have already reconciled and identified with your account. In theory, an agreement that says that 2 business days are required for credit of a check deposit to the lockbox reflects the amount of time it takes to clear the check through the banking system and receive the money. Some finance companies apply float to all items, including treasury checks, ACH (automated clearing house) or wire transfers even though those items have a much shorter clearing time. There is really no justification for float days on items paid by wire transfer. Some finance companies may specify a float longer than 2 days. Most of us understand this delays our receiving the money by the number of float days. But the more important cost is actually the fees that continue to accrue until you receive credit for the payment. The float days normally don t commence until reconcilement is complete. So you would need to add the float days to any reconcilement delay. If you are a government contractor, chances are you are paid by wire transfer. Let s say you are normally paid in 30 days or close to it. 10
Conclusion Settlement Schedule Daily Weekly Bi-Weekly Monthly Float Days 1 2 2 2 Days Added to Turn 0 5.5 9 17 % Cost Increase 0% 18% 30% 57% Two videos ago we addressed Periodic Fee and how they affect cost. It is important to note, that a Periodic Fee structure may increase the cost effect of float and settlement considerations and will make it much harder to compute the expected cost. Float Days specified in a factoring agreement delay payment to you and extend the clock on fees. Some factors and asset based lenders charge Float Days even on payments, such as wires, that are immediate availability items. The reconcilement schedule can further delay credit to you for payments from your customers and will extend the clock on the fees. The facts on these two features are usually not in the proposal so you would need to refer to the factoring agreements. As a general rule, look for low float days and daily reconcilement. 5. Whole Turnover Invoice Factoring Assignment The last video, titled Float & Settlement Credit, briefly addressed the assignment of receivables in invoice factoring and accounts receivable financing. This is when the borrowers customers are notified to make payments to a lockbox controlled by the finance company. It is very common practice in specialty finance. What has to be assigned? It is also very common practice for the finance company to require that all of your customer accounts be assigned to the lockbox, even those you do not specifically plan to assign. Some people in the industry may us the term Whole Turnover to describe this assignment requirement. 11
This kind of Whole Turnover does not really affect the cost of financing. Whole Turnover and Cost The term Whole Turnover can also mean that the borrower must not only assign all of their customer accounts, but they must also finance all of those invoices every month. If the borrower needs all of the financing they can get, this version of Whole Turnover does not add to the cost of financing, either. But if the borrower does not plan to factor everything every time, or thinks they may not need the money for the whole length of time the invoices take to pay, this version of Whole Turnover can very substantially add to the cost. For example, if a borrow bills $300,000 each month and will pay fees of 2% to finance that but they really only need to finance $150,000, the effective fees on that $150,000 in financing becomes 4%. Conclusion As a business owner, if you think you will be able to manage your cash flow so that you don t need to finance all of your invoices every month, watch out for a Whole Turnover provision that requires everything to be financed. Remember there is no problem if Whole Turnover just means all payments are assigned to the lockbox but you can still choose how much to finance based upon your business needs. 6. Invoice Factoring Facility Fees and Minimums Facility Fees A Facility Fee is a charge to set up the borrowing or factoring relationship. Most often, it is expressed as a percentage of the maximum facility or line amount to be provided. For example, if there is a 1% Facility Fee and the finance company has proposed a line amount up to $500,000, then the Facility Fee would be $5,000. Typically, this fee is due up front or is taken out of the first advance. Some finance companies will agree to take the Facility Fee in installments. The costs: A 1% facility fee adds 1% to the annualized cost If cash is short, payment of the fee can be a burden 12
Minimum Fees There are several types of minimums. Minimums should only come into play when your activity falls below your projected volume and even then, if the fee operates as a true minimum, you only pay the amount you did not cover with activity. Here are two common minimum structures: Minimum monthly financed volume If your financed volume falls below the stated minimum, this fee provision might specify that you owe the financing fees that would have been charged if you had financed the minimum volume of invoices. Example: Minimum Financing Volume of $250,000 A factoring fee of 1.5% of financed invoices Actual financed volume of $150,000 Shortfall against the minimum of $100,000 Minimum Fee Charge = 1.5% X $100,000 =$1,500 In addition to the $2,250 accrued on the $150,000 actually financed. Minimum monthly fees Very similar to the first but based upon fees charged rather than financing volume. If the fees on the financing provided in any month are less than the monthly minimum fee, you would be charged the amount of the shortfall. Example: Minimum Monthly Factoring Fee of $4,000 A quoted Factoring Fee 1.5% of financed invoices Actual financed volume of $200,000 Accrued Factoring Fees on the $200,000 = $3,000 13
Why do these fees exist? Conclusion Shortfall against the minimum of $1,000 Total Factoring Fee Charged = $1,000 shortfall plus $3,000 accrued fees = $4,000 In most cases, the finance company is trying to insure they cover known costs, such as: Account setup and due-diligence Reserving capacity for your line Payments to the broker or consultant if you were using one Economies of scale pricing risk Factoring and asset based lending agreements may specify Facility Fees that add to the overall cost of financing by their effective amount. More important may be the cash requirement to pay a facility fee if cash is tight. Minimum Fees may or may not add to the cost of your financing. It really depends on how the minimums are specified and whether or not you are likely to engage those minimums. Read the governing financing agreements carefully and understand the way all fees will operate. Think carefully about your business and whether or not you can expect to engage minimums. If you think your financing and business patterns may frequently incur minimum charges, it is important to realize that those charges could meaningfully increase the effective overall financing rate you are paying. If those minimums are set below where you expect your activity to be, the minimums will probably not affect your effective rate at all. 7. Application Charges & Out-of-Pocket Expenses of Invoice Factoring Application Fees First Real Work - In many finance companies, an application package triggers the first round of serious study and consideration of a borrower s request for a financing proposal. 14
Covers Some Up-Front Costs - Application Fees for financing are generally meant by the finance company to cover some of their incidental up-front costs of processing when there is still uncertainty that the deal will close. Test of Seriousness - It is also often regarded as a bit of a test of seriousness to be sure the prospective borrower is proceeding with the intent of closing a deal and not just casually exploring options. Vary Widely Application Fees can vary a lot in amount. Application Fees are typically a few hundred dollars and therefore do not importantly influence the overall cost of the financing. But some companies may charge a few thousand and some may have no Application Fee at all. With some providers, the Application Fee may vary with the size and complexity of the relationship being considered. Out-of-Pocket Expenses Conclusion Practically every finance company and bank will charge for their out-of-pocket expenses incurred to support the relationship. By definition, these should be items that the financing provider has to pay for as a hard cost explicitly and only to serve the borrower charged. It would normally not include the time spent by employees and incidental supplies. Examples: Wire fees, lien search and filing fees, credit reports, background checks, overnight deliveries, etc. Most Out-of-Pocket expenses should be fairly minimal in amount and would not importantly affect the cost of financing. However, some types of Out-of-Pocket expenses can be very significant and may materially change your cost of financing. Examples: Attorney fees, audit fees and travel for auditors, credit insurance. Application Fees and charges for Out-of-Pocket expenses, most often do not materially change the cost of financing. They are usually just not significant enough. Be sure to ask what items to expect as Out-of-Pocket expenses and consider whether or not any of them could be significant in your relationship. Ask for an estimate of total Out-of-Pocket costs. In particular, ask if the finance company intends to use attorneys, field examiners or credit insurance and what the likely charges would be for those. 15
8. Invoice Factoring Term & Renewal Contract Term In Business Law 101, business students are taught that a term is one of the basic requirements for a contract. The term of a contract is just the established time period for which the contract is effective before it must be renewed by the parties or automatically renews unless terminated by one of the parties. Some financing contracts expire at the end of their term but most renew automatically at the end of their term. Some may, after a first, annual term, revert to month to month. A term can be for any period of time. Most factoring and asset-based lending contracts have one year terms but some may be for shorter periods and some may be for two or three years. Notice and Means of Termination Most contracts specify what the borrower must do to terminate the contract either during its term or near the end of the term to prevent automatic renewal. a. The acceptable forms of notice, who must receive the notice where, and acceptable forms of delivery are typically specified. b. Notice periods are common requiring 30, 60 or 90 days advance notice to terminate. If you think you may not wish to renew a financing contract, it is important to know how and when to serve notice of termination to avoid automatically commencing a new term. Early Termination Fees Factoring and asset based lending agreements vary widely in the fees that they specify for early termination. Some agreements may have no financial penalty for early termination but most do. Most factors and lenders include such early termination fees to insure they are covered for the costs of reserving lending capacity and, in most cases, the early termination fees are materially less than the financing fees in the remaining term would have been. The ways the early termination fees are specified vary. A few examples are: A fixed dollar amount 16
Conclusion A percentage of the line amount or the average financing activity A fixed dollar amount for each month of the term unfulfilled Sometimes, the reference to early termination penalties may be vague or not clearly quantified. This can imply you would owe all forgone financing revenue and the uncertainty invites dispute. The term specified in financing agreements for factoring or asset based lending varies from month to month to as long as two or more years. Most agreements renew automatically and there are usually specific notification requirements for terminating or preventing renewal including advance notice periods. Fees for early termination of an agreement are common. These provisions may be negotiable to some extent. It is very important to read financing agreements thoroughly and have them reviewed by a trusted, experienced attorney. Make sure the term, notice requirements, and potential early termination fees are appropriate for your plans. 9. Understanding Aged Items in Invoice Factoring How old is Aged? Most factoring and asset based lending companies establish limits on how old an invoice can be to be considered eligible for financing. Most commonly, this is 90 days from the original invoice date but in some cases the limit may be less than 90. The theory behind this is that invoices that take substantially longer than 30 days to pay may take on a higher risk of non-payment. Even when the factor or asset based lender understands the circumstances, they may be limited by the borrowing agreements they have with their own bank. Additional Fees Even when the age of an invoice does not in-and-of itself cause that invoice to be ineligible for financing, there usually are additional fees that kick in beyond a certain age. 17
These fees can substantially change a borrower s financing costs. The Liquidity Crunch May be the Greatest Concern Conclusion If the financing agreement requires that aged items be disqualified from the financing, solving the problem can create a cash crisis for the borrower. Virtually all finance companies will require repayment of an item that shows signs that it may ultimately not be paid by the borrower s customer. However, some finance companies may require that the borrower repay the item either in new cash or in withheld advances or payments on other invoices, even if the aged items show every other sign of being fully collectible. The finance company may even stop advances on new invoices to that same customer on the theory that something is wrong in that relationship. Review the financing agreement carefully with trusted advisors and understand when any aging triggers may kick in. Be sure to fully understand the finance company s practices and policies for handling items that do cross the aging threshold. Must those advances be repaid? If so, how and how quickly? What will the charges be? Are new invoices to that customer now ineligible? Assess the likelihood that you might experience an aged item. Diminished liquidity and higher cost is never a good thing but you certainly want to be sure a rare event would not threaten your company s existence. 10. Special Services of Invoice Factoring Providers What is meant by Special Services? Every good business is always looking for ways to be more valuable to customers and factoring companies are no different. Sometimes the finance company s management realizes that they have a particular expertise or ability that will allow them to do something extra that is not really factoring or asset based lending. Some examples may include: Purchase Order Financing Earned/Unbilled Financing 18
Payroll Services Equipment Leasing Escrow Services Billing Additional Fees Conclusion These special services may be responsibly provided but they are definitely departures from the core service of most factoring and asset based lending companies and may come with a substantial incremental price tag. Outsourcing special services can be valuable but make sure you know what the costs are and make sure that a more sophisticated and less expensive solution is not available on the market. Buying everything in the same place can be convenient but it may cost you more, give you less, and will leave you less mobile and with all your eggs in one basket if things do not go well. This outline should help you make informed decisions when comparing invoice factoring or asset based lending proposals. Watch the entire video series on invoice factoring costs on Federal National s blog or in the video library. Follow us on twitter, LinkedIn or Facebook or subscribe to our blog to receive more information about financing and small business.. 19