Taking The Fear Out of Factoring

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Cash flow is king, and it's the factors that give you the cash flow," says Larry Rosenblum of Nylon. "Factoring looks expensive, but all these other services are provided."

Historically, factoring was regarded as a rough business. It was wise for most companies to stay clear of it if only because of factors' single-minded emphasis on collections; factors were known to make people offers they couldn't refuse. Now factoring is considered just another kind of so-called "asset-based commercial lending," a category that as a whole grew from $100 billion of credit extended at any one time in the early 1990s to more than $325 billion today. Factoring as a component of that larger category (which also includes loans secured by real estate, machinery, goods, and other assets) accounts for about $100 billion of outstanding credit at any one time. (Turnover brings the total to more than $1 trillion a year.)

With the likes of GE Capital, Wells Fargo, and even UPS in the game, any fear that using a reputable factor is akin going to a local leg breaker should be gone. (See this list of factors who belong to their main trade group, the Commercial Finance Association, whose members include all sorts of asset-based lenders.) However, a caveat emptor is in order: Business owners need to have their attorney or accountant check out the bank and customer references of any factor, including those on this list. Factors have been known to go out of business still owing their customers substantial amounts of money held back in reserve from invoices already paid up. Even worse: Some shady businesses that identify themselves as factors are really just loan sharks fully prepared to threaten or coerce clients who owe them money.

A reputable factor, though, can save a business. Consider James Choung's $6 million-a-year laundry and dry-cleaning business, Newtex. His business was started with help from a Korean American bank, as are many Korean enterprises. Choung came to the United States to train as a nuclear engineer and had worked on nuclear submarines in Newport News, Va., until the American Navy stopped building them. With a wife and four children (in private schools) he needed income, and he decided to buy a tony dry cleaner in Manhattan. He soon expanded his South Bronx plant, selling laundry services to restaurants and hotels, including clothing for hotel guests.

His books told him he was making a lot of money, but as he hired people and leased machines, he found his cash flow out was higher than his cash flow in. His monthly bills to his customers were preceded by several weeks of expenses. ("The monthly bill," he says, "just starts the clock."). He found that few restaurants and hotels paid in less than 30 days after the receipt of his bills. And many took more than 60 days.

Choung's primary Korean bank was unwilling to study the credit ratings of New York City restaurants and hotels or to take on faith that receivables would eventually be paid. Only the discovery of factoring kept Choung alive. "For me," he says, "factoring is cash flow." Choung now employs 60 people, and nearly all his $6 million in annual revenue passes through the hands of his factor. Without it, the business couldn't have survived.

Dry cleaning isn't that far removed from the industries where factoring was originally concentrated. In the garment and shoe trades, a retailer had to stock a large variety of sizes and neither manufacturers nor wholesalers could afford to finance the storekeeper's inventory: Factors filled the void. Today, factoring has become significant in the financing of many other businesses that depend on fast billing turnaround, such as hardware stores, pharmacies, florists, wine and liquor distributors, parking garages (for commercial accounts), garden supply shops, pest controllers, and temp agencies.

The list is growing. As more mainstream lenders (or their subsidiaries) look for a slice of the lucrative factoring pie, new customers are needed. One such company not part of the traditional factoring clientele is Arrin Systems in Carlsbad, Calif. Arrin is in the business of conducting employee background checks for companies across the country. Its revenue exceeds $2 million a year, and its clients include everything from paralegal firms to casinos. Arrin e-mails its factor a weekly list of each background report completed and billed to a client. The factor pays the bill, less 3%. To protect itself, it also deducts whatever sum will maintain a steady 20% reserve on all Arrin's uncollected bills, one of many stringent conditions factors may demand to mitigate their chance of loss.

It is, after all, a risky business. The primary concern to the factor is the creditworthiness of a business's customer. For that reason, almost every factor has a staff of "credit investigators," often experienced bank lending officers wearing new hats. It's important for businesses to realize a customer whose credit is being evaluated by outsiders can get irritated. It's wise to take that into account before deciding to put a customer's bill into a factor's hands.

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