Lesson Learned: Borrow against Fixed Assets; Factor Your Account

Through the ‘90s and the early part of the 21st century, it became common practice for small and mid-sized business owners to seek financing for their accounts receivable wherever they thought they could get it cheapest. It is important to watch your pennies, but whatever happened to “you get what you pay for?” It seems factoring companies during this time period decided it wasn’t important to sell the distinctions between themselves and banks. Instead, many began competing with banks for factoring business by offering pricing that looked a lot like what banks were offering. Most of these factoring companies provided few of the services factoring companies are known for— and the services they did provide were not delivered well. They simply could not afford to offer a high level of factoring service at bank rates.

Should I borrow or should I factor?

This was a huge strategic mistake for our industry, because factoring companies play a role that banks cannot. It costs money to play that role well, lots of money. A factoring relationship is unlike a bank relationship in that there is daily communication between a factoring company and its clients. Constant communication is necessary in order to provide the expert credit guidance and collection services that a factoring company should offer. At most, a borrower speaks to his banker once a week or even once a month, and most banks that provide factoring drop the ball when it comes to credit and collections services.

Many banks see lending against or factoring accounts receivable only as a necessary evil, a service they must provide in order to attract cheap deposits or other fee-generating services. In fact, banks have historically shunned the practice of lending against invoices or accounts receivable, viewing their role as lenders against fixed assets, like real estate, equipment or machinery. Even today, many banks will not even consider lending against invoices or accounts receivable unless the borrower has significant equity in other assets and is willing to pledge those assets to the bank as additional security. Banks want commercial relationships that lead ostensibly to other things, like deposits, cash management services, investments, consumer lending or mortgages.

Factoring companies, on the other hand, are accounts receivable and invoice funding experts. It’s what they do, and if it’s a good factoring company, it’s ALL they do. Factoring companies do not shy away from funding invoices or discounting accounts receivable. They embrace it.

By its very nature, factoring accounts receivable can be risky. Factoring companies do not look to other assets as collateral or their clients’ ability to repay; they are concerned primarily with only one thing: Will the invoice pay? Factoring companies should and usually do charge a premium to cover the incremental risk involved with a factoring transaction. They should also charge higher rates than banks because of the credit and collection expertise that comes along with factoring.

During the time period we have been discussing, many factoring companies lost their way. They lowered their rates to compete with the banks and, in some cases, matched or came very close to matching bank rates. In the process, the factoring industry became more like the banking industry. All of a sudden, not only were banks lending against or factoring accounts receivable for their customers, but now factoring companies began lending against and factoring accounts receivable at bank rates and on bank terms. It all sounded too good to be true, and companies were stumbling over each other to get your business.

The End is Near

In the mad rush in the factoring industry, many distinctions were lost. Some truths, however, could not be escaped: Factoring companies offer funding without debt. A bank loan, by definition, is debt.

Another more important truth was beginning to emerge by the fall of 2008: Those banks and non-banks that entered the factoring realm as a sideline in the ’90s began abandoning their clients in droves. Companies that were more famous for building helicopters and toaster ovens now were closing their factoring subsidiaries. Having badly underestimated the costs of factoring, they ceased to be profitable enough to justify their existence to headquarters. Some of their clients were lucky enough to sign on to new factoring companies before they lost their funding. Others were not so lucky.

Lessons Learned

Many clients we’ve signed in 2008 and 2009 who had become accustomed to frenetic competition in the factoring industry over the past decade and a half have come to appreciate the piece of mind that comes with knowing your factoring company is not going to be forced out of business by a corporate parent. For many, we were there when they needed us, when they were forced to seek a new factoring relationship at the spur of the moment. True, we charge a few more points per year than they may have paid in the past, but those points allow us to manage the turbulent times so we can provide uninterrupted, predictable funding for all our clients, now and in the future.

Author: Tony Furman
Copyright 2009
Interstate Capital Corp.

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