Business and Finance
This is a financial article I wrote about Receivables Factoring.
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FACTORING - THE BASICS OF RECEIVABLES FACTORING
Your new startup company’s fantastic new product is poised to be the next great thing in computer accessories for 20 somethings. You’re getting rave reviews both in print and on the web, and everybody’s gotta have one. The orders are pouring in from eager retailers who can’t keep ‘em on the shelf. And you’re not going to disappoint them. You ramp up production, buy new equipment, hire more engineers and buy tons and tons of parts to keep up with the crazy demand.
THE CHECK IS IN THE MAIL
But your fast success has created a serious snag. A manufacturer rarely collects cash on delivery of product. The company typically sends a bill, an invoice, to the retailer, asking for payment in a certain amount of time. In finance, every action has an equal and opposite reaction, and in this case the retailer’s invoice becomes your receivable. Receivables are promises to pay within a certain, definite time period. Those retailers are solid performers, and you can be sure that most of them will pay. But you have to pay those parts people and equipment suppliers now because they’re bigger fish then you are, and bigger fish eat first. And you certainly have to pay the employees now, because Uncle Sam says you have to.
WHAT TO DO?
You’re a hot new startup, and hot new startups are very often under-funded, so you can’t dig into the old deep pockets. You haven’t yet established your long-term credit worthiness, so it’s going to be hard to get a loan, and the interest will be sky-high even if you can.
The answer may very well be receivable factoring. Also known as invoice factoring, the process has been around at least since the ancient caravans were plying the Silk Road to Old Cathay. What’s new is that it’s only recently been available to smaller companies in the U.S.
Here’s how it works. You sell the receivable to a factoring agent, who immediately pays you a percentage, perhaps 75%, of the total amount of the invoice. It then becomes the factor’s job to collect the receivable from your customer. When that’s done, the factor remits the other 25% to you, minus the percentage he charges, which may be from 2% to 5%. That 2% to 5% is your cost.
One of the great advantages to receivables factoring is the ability it gives you to benefit from you customer’s credit rating, because what the factor charges for his service is based mostly on your customer’s creditworthiness, not yours. This only makes sense, because the factor is betting on the willingness and ability of your customer to pay his bills, not yours. This is because, after all, you don’t owe him anything.
Also, since you are now in no hurry to collect from your customers, you can save a lot of money by not offering early payment discounts. In fact, with your vastly improved cash flow, it’s now you who are in a position to demand early payment discounts from your vendors.
Another important advantage is that your accounting and finance department can be much smaller, because you don’t need an accounts receivable department or a collections department. That’s handled for you and for others by the factor. And, because the factor does the same job many times over for many different organizations, he enjoys an economy of scale that can work for both of you. Let him do what he does best, so you can concentrate on the creative stuff, which is what you do best.
KEEP WHAT’S YOURS
The other typical way for a small, new, innovative company to obtain the money it needs to keep the juices flowing is via the venture capital market. But this pathway almost always involves giving up a large chunk of your company’s equity, which means permanently losing complete control over your brainchild’s destiny, rather than merely losing temporary control over receivables. Equally important, choosing this permanent solution to a temporary problem means forever forgoing a large chunk of the profits.