Why factoring is often the astute solution for the SME Entrepreneur (Part 1)

Editorial Board Member, Mark Mandula, Managing Partner, United Capital Funding, USA, makes a comparison between factoring and traditional bank loan.

Competition today for the select number of entrepreneurs here in the United States that we seek to serve as a traditional factoring firm has never been more intense. There is a wide array of options available to SME’s; running the gamut for MCA [Merchant Cash Advances, avoid!] to very traditional bank loan products.

The title of this short article is an interesting one to think about in today’s very competitive and unstable economic environment. I believe that in many cases, B2B and B2G Accounts Receivable “AR” factoring can be a superior solution for the entrepreneurial business, if objectively compared to a costs and constraints of a loan from a traditional lender or funding source. Yes, in most cases it is true that the cost of factoring may exceed the costs of a line of credit at a traditional bank. However, the practical reality is that many if not most entrepreneurial SME’s do not and will not meet the stringent requirement imposed by traditional banks in the marketplace today.

When compared to more traditional small business capital funding sources, Accounts Receivable factoring is often not nearly as expensive as it appears and is almost always much less restrictive than a traditional bank loan or line of credit. In addition, personal (and corporate) credit cards have been the backbone of capital for many small businesses for years, but conditions are making such sources increasingly costly, thereby potentially making B2B and B2G factoring in many cases a less expensive and more attractive solution for many SME’s.

Let’s do an apples to apples comparison on a bank line of credit and factoring AR

I think it is important to compare, on an ‘apples to apples’ basis the benefits and costs of professional B2B and B2G AR factoring to a line of credit or loan from a traditional funding source like a bank. I have identified a range of key points to compare, when examining bank lines of credit and Accounts Receivable factoring. In each case, I will present comparisons between bank lines of credit proposals to our professional B2B and B2G Accounts Receivable factoring model.

1. Credit facility. With most bank lines, the credit facility will be a fixed amount, usually expressed on a total $ value basis. This is determined by an in-depth analysis of the profit and loss of the business, net worth, margins, ratio analysis, etc. There is almost always a minimum volume requirement that must be used or drawn on a typical bank line of credit.

With Accounts Receivable factoring, there are usually no such constraints, limits or minimum funding requirements. Due to the fact that the amount of available credit is driven by the credit quality of our clients’ customer, bank criteria such a net worth, balance sheet composition or profitability are secondary consideration for the Accounts Receivable factoring firm. This is a significant advantage for an entrepreneurial business, especially one without a long track record of performance and/or a startup SME.

2. Maturity. With most bank lines of credit, there is a maximum maturity that the bank will provide the funding to a SME. It is quite common to see two or three years as a maturity for bank lines. While this might at first glance be a desired length of time, what happens if the SME no longer needs or wants the line of credit? Perhaps a significantly better/lower cost source of capital comes available, or the SME decides to take on a partner or alternative capital source? What then? If or when this occurs in most cases, the entrepreneur could be stuck. Most bank lines have not only a maturity requirement, but a minimum volume usage requirement. If there is not a minimum, it is common that the bank charges the SME an ‘unused line fee’. This guarantees they will earn something on the relationship, even if the SME is not drawing down on the loan or line of credit.

With Accounts Receivable factoring, this is not the case. In our unique funding model, there is never a minimum volume or fee assessed for the SME. In addition, the typical length for a factoring contract is one year or less. Most agreements can be renewed automatically, assuming both parties want to continue the relationship. So ask yourself a simple question: Why would I lock my business into a long term line of credit, potentially exposing myself to costs and constraints that I cannot control or predict?

3. Increase in the credit facility. With most bank lines of credit, the amount or maximum loan amount available is set or capped. This is done to insure that the bank is not exposed to more risk than what was agreed upon when the line of credit is approved. In most cases, a SME doesn’t want this limit any higher than they realistically anticipate using, as closing fees, unused line fees, taxes or filing fees [if applicable] are usually a percentage of this amount. In addition, if the SME hired a broker to secure the line of credit, often their fee is also driven by the approved amount. So it makes economic, although often not long term strategic sense, to have this number be conservative.

But let’s take a simple example to illustrate how dangerous this approach could be to the health of a SME’s entrepreneurial business. Say they have been working on the ‘big deal’ for a long time, and one day they land it. Congratulations!

But what happens if the amount of money they need to purchase the raw materials, hire people, produce the product or afford the increase in payroll is woefully short of what they have? The obvious answer would be to go back to the bank and request a significant increase in your line of credit. Unfortunately, in the nearly 20 years of serving our entrepreneurial clients I have seen over and over again that while in theory this should be easy to do quickly and cost effectively, it rarely happens. Too many times the decision-making process at the bank and the required timeframe for the SME to mobilize are weeks or months apart. In most cases, a significant, or even small, increase in the credit facility requires a complete new application, underwriting, out of pocket costs to get an approval/increase by the bank.

In addition, there are usually fees to reapply with the bank. So if the SME’s capital, already stretched by this new client get further depleted, causing additional risk and worry. Granted, if the SME plans ahead and cues the bank into what is happening, it should be able to avoid this chain reaction from occurring. It has been my experience again that few businesses have or take the time to constantly court their bank.

On the other hand, with Accounts Receivable factoring, no such protracted decision making process or time constraints usually exist. This is due to the fact that all current or potential clients can be pre-approved by the Accounts Receivable factoring firm well before/if the ‘big deal’ is landed. This way, the SME is in the driver seat and can insure that when they need the capital, it will be there. Finally, there are usually no fees to ever have an increase in the total factoring relationship, preserving precious capital for use in running the day to day operation of their SME.

4. Collateral. With most bank lines of credit, the collateral requirement, or assets pledged to secure the line of credit are significant. From the bank’s perspective, the more collateral, the better. So in most cases, the collateral required is global, or 100% of all currently owned assets of the business. In addition, this commonly includes all future assets acquired, for the term of the line of credit.

While this might sound reasonable, the approved amount of the line of credit can be a small fraction of the value of what is required to be pledged as collateral.

The other very important fact to consider is that once assets have been pledged to the bank to secure a line of credit, it is nearly impossible to get them released. Coupled with the fact that most lines of credit agreements require two or three years terms, this can eliminate any future borrowing on pledged collateral without prior approval by the bank. Again, there are very few banks that ever release previously pledged collateral without some other asset being added to replace the asset. This can seriously impact the SME’s ability to expand or cultivate other funding sources, such as equipment leasing firms, commercial mortgage providers and other sources of long term capital.

On the other hand, with professional B2B and B2G Accounts Receivable factoring, the only collateral that is required to use this flexible funding tool is the purchased accounts receivables. This allows the SME maximum flexibility and does not eliminate the possibility that other assets [such as real estate, fixed assets, etc.] can be used as collateral in the future.

5. Personal Guarantees. With most bank lines of credit, the bank will require that the owner, owners, significant outside shareholders and maybe even the Directors personally guarantee the loan. It is true that in some cases, the bank will not require owners to personally guarantee the loan. However, particularly for SMEs, this is the exception rather than the rule.

It is common for many businesses to have more than one, or even many owners. Many may have different goals, financial needs, and capacity to repay a loan if the business has to, or is forced to at a less than desirable point in the year. If the SME has multiple owners, it is imperative that they understand and confirm exactly what they are getting yourself into before they sign any loan or line of credit document. Don’t assume that what you have been told, or believe the financial strength of your fellow owners is accurate. The bottom line is that if the bank calls your loan, all who signed may need to [individually and collectively] come me up with the money.

Unfortunately, these kinds of discussions rarely occur, and if they do, can be a source of conflict and angst. If family is involved, there is another element of stress and anxiety that often prevents owners from discussing openly and honestly such issues.

The statement of the obvious is that when anyone personally guarantees any loan or line of credit, everything they have worked hard to achieve is at risk. Even the most creative asset protection strategy could potentially leave them exposed. So carefully consider this as you research funding options for any business.

With factoring, the contrast between the line of credit required to be personally guaranteed could not be starker. With most factoring agreements, there is not a true personal guarantee required. What is required would be a reasonable validity statement signed by the owners of the business. This states that those receivables to be sold/acquire are valid, accurate and constitute a final sale to the purchaser.

to be continued with Part 2