Understanding the Power of Factoring

Factoring is a method of small business finance that his been around a long time, several hundred year in fact in the United States.  In fact, if you find yourself in Savannah any time soon, make it a point to take the tour through a beautiful area called “Factors Walk”.  Here you will find rows of warehouse that date back to the mid-1800s when “King Cotton” was the South’s most valuable export. Here the Old Savannah Cotton Exchange resides but now is surrounded with a section dedicated to shops, restaurants, and hotels and another area made up of residences that are mostly vacation homes rather than the myriad of old warehouses.  And naturally at the time around any export of goods such as cotton, there was a thriving group of middlemen known as “factors” that purchased the raw product farmers, warehoused the goods, and sell it to manufactures of clothing and fabric.  While the factors no longer find themselves in the business of warehousing goods, they are more than ever in the3 business of financing and far from limited to exports transactions.

Historically factoring has been a method of trade finance for hundred of years and it now accounts for trillions in transaction worldwide.  While specialized banks and factors provide billions of financing in to businesses in North America, it is only 2% of the total estimated worldwide volume of 2,724 billion euros with the top five factors in the world (France, Germany, United Kingdom, Italy, Spain) accounting for roughly 70% of the market. So, has you now are beginning to learn…factoring is BIG BUSINESS.

So…How Does Factoring Work?

To understand just how beneficial (and necessary) factoring can be, it is easier to see its need if you first see the problem it solves.  Let’s look at an example.

Lets assume an entrepreneur (we’ll call him Phil) starts a landscaping business and provides yard mowing to other companies.  For their weekly services to his customers, Phil sends an invoice at the end of each month and grants his customers 30 days to pay.  In effect, Phil is waiting for up to 30-60 days to get paid for some of his work.

Phil pays his employees every week and since he needs to wait up to 60 days to get paid, Phil must have “cash on hand” to pay his workers while he waits to get paid for his invoice.  That works fine as long as the Phil has the “cash on hand” to pay his workers.  But what if he does not.  What if Phil is fortunate enough to attract two or three new large clients but that also require 30 days to pay their invoice.  Phil will naturally need to hire more labor to do the job to make payroll.  But, as most fast growing small businesses, Phil is about to run out of cash.  How does Phil solve the problem so he can accept the new large clients?

It’s All About Purchasing Invoices

So Phil’s landscaping company has a working capital problems and he has two ways to solve it he thinks.  He can…

  • Decline to take on the new accounts (bad idea)
  • He can get a loan

But Phil already knows he’s going to have a problem getting a loan.  First, he has no collateral and he already borrowed everything he could from friends, relatives, and credit cards just to purchase the lawnmowers and equipment he needed to get the business started.  So a loan is no option.  He needs something else.  He need to finance his invoices.  And fortunately, there is a financial tool available to him to do just that.  FACTORING!

Factors are specialized financiers that are in the business of “purchasing” invoices.  In Phil’s case, Phil will invoice his clients (including his new BIG clients) and as normal, provide them 30 days to make the payment.  But rather wait, Phil will immediately sell the invoice (and rights to payment) to the factor who will pay cash to Phil and will receive the payment from his clients when do.  So the clients will still enjoy the 30 day terms of payment.  Phil gets the funds to pay his employees on time.  And the factor, for its services, will earn a small “factoring fee” of about two percent (2%).  Phil utilizes the factor’s services every week.  And, in fact, Phil now markets for more and more new clients since he now has unlimited funds for finance.

But One Question?  How Did Phil Find About Factoring?

Although factoring is an enormous financial tool worldwide, many (and certainly most) small business owners simply don’t know much about it.  For the most part, when a bank turns down the loan, most owners are completely lost.  For some business owners in Phil’s predicament, however, luck will be in his side.  In this case, he may fortunate to find a “middleman” that knwos all ablout the factor transaction.  He will find a Freelance Factoring Broker.

Although everyone knows where they can find a bank, few are familiar with the fact that there are roughly factors and commercial banks with factoring department.  For example, Wells Fargo has an enormous factoring department, but few customers (and even branch office) know it exists.  Additionally factors themselves have employees similar to a bank’s loan officers that are in charge of dealing with the Phil’s of the world but the job is simply too large.  And that’s where factoring brokers come in.  You see, very few individuals are aware that virtually all factors (and most banks as well) pay referral fees for ANYONE that refers a factoring client.  And most clients like Phil find a factor through a bookkeeper or similar as the result of a “one tine” referral, there are a group of entrepreneurial individual that have found out the secret of factoring as well as many other alternate financial products available to operators such Phil when turned down after applying for a traditional bank loan.  Once properly trained, these “brokers” seek out small business clients through various methods and make themselves available to assist all types of small business owners in sourcing the capital and financial tools, just like factoring, they need.

Want to discuss this article?  Post your question to the IACFB Factoring Group on LinkedIn.