How to make the most of the source of capital everyone loves to hate -- factoring.
How one start-up company found happiness with the source of capital that everybody loves to hate -- factoring
Ada, Okla.; population 17,500. Everyone knows everyone here. It's the kind of place where a crop duster can count the owner of the local bank as a friend.
Indeed, long before Clyde Leach began spraying peanut and alfalfa crops, his older brother was double-dating with John Lowry, the future president of Oklahoma State Bank. Lowry's wife, Edwina, started a cosmetics business just about the time that Clyde's wife, Jamie, designed a cloth and Velcro restraint to keep their baby son in his high chair.
So whom did Clyde and Jamie look to for working capital when they decided to turn Jamie's invention, dubbed Wiggle Wrap, into a business? Not John Lowry. "When you have a new idea, especially here in Oklahoma," says Clyde, "banks want to see the bottom line." They didn't go to control-hungry venture capitalists. Instead, they unearthed one of the least used -- and certainly least respected -- financing techniques available to start-ups: factoring.
Factoring doesn't involve borrowing money, but rather selling your receivables for cash. It has a sorry reputation primarily because it's expensive compared with ordinary bank loans. For example, financing monthly receivables of $100,000 through a conventional line of credit would cost about $12,000 in yearly interest charges, while factoring those receivables could cost $36,000 to $60,000 annually (see "The Awful Truth," page 2).
Naturally, you'd avoid paying that kind of money if you could borrow elsewhere. The companies that factor usually don't have anywhere else to turn and often are desperate for cash. Troubled companies, for example, and bankrupt companies. Certainly not your kind of company.
Or so Clyde and Jamie were told by bankers and accountants in early 1988. The trouble was, says Clyde, C. J. Leachco Inc. didn't have any other options. Clyde had already sold 8% of the company to individual investors to raise money for start-up materials, a patent search, and a patent application for Wiggle Wrap. The Leaches were willing to give up more of their equity -- up to 30%, they decided -- but not all at once. Clyde's plan was to sell Leachco's shares in stages, as the value of the company went up. That way, the couple could raise more capital per share each time.
In the meantime, they needed cash to buy fabric and pay their contractor for the Wiggle Wrap orders that had begun trickling in. Waiting even 30 days for Leachco's new customers to pay was too long. Six months later, when orders began doubling and tripling, Leachco would need even more cash just to keep up with the growth.
Enter Cliff Boyd, a former accountant and auditor who established Cash Flow Management Inc. in 1979. Clyde found Boyd through a Leachco supplier who had used his services. After visiting the Leaches and evaluating Leachco's three retail customers, Boyd agreed to factor Leachco's receivables. The first month that the Leaches factored, the company's receivables amounted to $1,100. During the past six months, they've ranged between $20,000 and $24,000 per month.
Here's how it works. Leachco types up its invoices and ships them to Boyd's Duncanville, Tex., office. Boyd enters the billing amounts in his bookkeeping system, stamps the invoices payable to Cash Flow Management, and sends them on to Leachco's customers. Boyd also immediately pays Leachco. He charges a 5% discount, which means that he gets 5% of the value of the invoices. The Leaches get 95% -- but not right away. Boyd sends them a check for 75% of the total within two days and the remaining 20% when Leachco's customers pay him.
So, if the Leaches ship $20,000 worth of invoices to Boyd, they receive $15,000 two days later. They get the last $4,000 within a month, because Leachco sells most Wiggle Wraps under terms of net 30.
What if customers don't pay on time? Boyd's discount goes up. Boyd charges 7% on invoices that are paid between 31 and 60 days after being billed, and 9% on those that come in during the next 30 days. When a bill hasn't been paid after 90 days, Leachco buys it back.
The Leaches are thrilled with this arrangement, even though a 5% discount is a hefty charge. Jamie likes the administrative support that Boyd provides: complete credit checking of all customers, biweekly updates on each customer's payment history, phone calls to collect from slow-paying customers. She figures that Leachco was able to get by with just a part-time clerk for the first six months, thanks to Boyd. Boyd has also introduced the Leaches to some important business contacts, and he's been a useful reference in trying to win large retail accounts, such as J. C. Penney.
All of this comes at an enormous price: profitability. By incorporating such a high variable expense in their operations, the Leaches have dramatically raised their cost of production. That means it will take a much greater volume of business for them to start making money. With Leachco's current cost structure, Clyde figures that the company will break even with monthly orders of $45,000 or so. At that volume, their yearly factoring costs are $27,000. If, instead, they had a $45,000 line of credit available to them at prime plus two, or 12%, their annual interest costs would come to $5,400. Obviously, with conventional financing, the Leaches could be logging profits much sooner.
But the Leaches couldn't -- and still can't -- get conventional financing. Leachco doesn't have the earnings to pay back debt. Nor does it have any equipment or real estate to pledge as collateral. If it weren't for factoring, Clyde and Jamie argue, they would have a much tinier business or no business at all. Instead, they have been able to grow Leachco from a start-up with two retail accounts in mid-1988 to a company that is writing $25,000 in orders monthly from a list of customers that includes Toys "R" Us and J. C. Penney two years later.
For the Leaches, the real verdict on factoring is still out. If they can show profits, and show them consistently, while still factoring, it will have been the right thing to do. For then they'll be able to arrange bank financing, and the cash that had been eaten up by ultrahigh factoring expenses will instantly enrich profits. That's what makes factoring such a challenging proposition. It's the best thing to do only if you're sure that, someday, you won't have to do it.
IS FACTORING FOR YOU?
When all else fails, it may be your best bet
When all other financing sources have turned up nil, factoring may be your only alternative. Once primarily used by companies in the garment industry, factors now work with a broad range of industries. You can find one by looking in the Yellow Pages and asking your suppliers and customers for references.
Here are two things to keep in mind to make factoring work for you:
* Factors are less closely regulated than banks, so check them out thoroughly. Talk to the factor's current and past clients. Look for factors who have helped customers make the transition to bank financing.
* You have room to negotiate. Factors actually buy your receivables, so they're far more interested in your customers' creditworthiness than in your company's. Try to negotiate the lowest discount (they range from 3% to 10%, but average 5% to 6% of the value of the receivables) and the lowest reserve -- the portion of your payment the factor holds onto until he's paid.
THE AWFUL TRUTH
Factors may keep your business going, but you'll pay for it
Jamie and Clyde Leach's 5% discount fee doesn't sound so bad, does it? The prime rate, after all, has been hovering around 10% for months. But actually factoring is many times more expensive than borrowing from a bank. Here's why:
Monthly receivables $100,000
Terms Net 30
Bank line of credit $100,000
Interest rate Prime + 2 (or 12%)
$100,000 x 12% = $12,000 in annual interest costs
Monthly receivables $100,000
Terms Net 30
Factoring discount 5%
$100,000 x 5% = $5,000 in monthly factoring fees
$5,000 x 12 months = $60,000 in annual factoring fees
In this example, factoring fees are five times as much as interest charges would be. While that's a shocking difference, factors do provide services that banks don't. In addition to substantial administrative support, factors give clients important credit information about their customers. Most important to fast-growing companies: once your customer is approved, you can exchange all its receivables for cash -- even if you get an order that's a whopper. In contrast, a bank is likely to cut you off once you draw down your line of credit.