Taking The Fear Out of Factoring
When the United States invaded Afghanistan, the armed forces needed a great deal of infrastructure support, everything from electric generators to water purifiers to road-repair machinery. Among the companies the government contracted to supply such things, and get them to where they were needed, was a South Carolina outfit called IAP Worldwide Services, specialists in logistics. Before IAP delivered the goods, it had to buy them and meet payroll. IAP faced one of the classic business problems: Business was good but cash flow was bad. To get the required cash, the company turned to Rockland Credit Finance in Owings Mills, Md., one of a flourishing number of "factors." Factoring is among the oldest forms of banking (during the Renaissance it helped make the Medici family very rich), but it doesn't work the same way as an ordinary loan. Instead of advancing cash to a business on a pledge that it will repay the bank down the road, the factor actually buys the legal right to collect a company's outstanding invoices. The factor gets its money when the invoices are paid. The business gets its money now, minus a fee that can run as high as 3% of the amount due.
Factoring now accounts for more than $1 trillion a year in credit, triple what it was in the early 1990s. When the economy slowed down these past two years, so did factoring (after all, with fewer invoices to buy, less money could be advanced by factors). But insiders report that as of last summer, there has been the beginning of a turnaround. Factors are not only putting out more money but are willing to take greater risks than a year ago.
What's more, in what looks to be the wave of the future, tech-savvy factors have created online lending services that allow a steady flow of small invoices (sometimes just a few dollars each) to be paid to a business owner almost immediately. The factor takes care of all the paperwork, while the company follows the progress via the Web. Everything is covered, from generating the invoice (in what can look to the customer very much like a credit card transaction) to cashing the check to depositing the funds in the company bank account.
"We're online," says John Fox, of Rockland Credit Finance in suburban Baltimore. "The client can see all. Everyone is moving in that direction."
What has made factoring even more attractive of late to many smaller-size businesses has been the growing popularity of "cash management" by big companies. In real life that means small companies that sell to big companies can expect to be paid very slowly. "Can I put GE on credit hold because it takes so long to pay?" asks Helma Mazon, of Mazon Associates in Irving, Texas. "No. We know it's going to pay." The problem isn't getting any better. "They're teaching cash management at business schools," says Mazon. "Trust me. They are." In the last few years, ironically, credit bureaus that handle reports on people refinancing mortgages have become big customers of factors because the banks to which they sell the reports are experts at cash management. (And it's just too bad if they can't get a loan from the same banks that owe them money.)
Wal-Mart, the world's biggest retailer, has created a new class of companies that need factoring because it also stretches out its payments. The vendors can't complain because Wal-Mart is such a huge source of business. From the factor's point of view, this is an ideal situation, because there is almost no risk of Wal-Mart never paying up. Yet banks usually won't extend a loan to small companies in this situation because they typically expect a whole lot more collateral to back up a loan than just a contract with Wal-Mart.
Most companies are still better off borrowing from their bank rather than selling their accounts receivable to a factor. Bank interest rates are much lower than the "discount" the factor will demand when it buys the right to collect invoices. And it is literally a discount. A factor will typically pay 2% to 3% less than the face value of an invoice. A 2% discount for an invoice due in 30 days is the equivalent of a hefty 25% a year.
But banks are backward-looking: They want to lend against the balance sheet a company has already achieved. Businesses looking to expand may find that a factor will provide working capital for growth when the bank won't run the risk. Even with only a prospective order in hand from a client whose propensity to pay up is uncertain, a business can turn to a factor to see if it will assume or share the risk. And to the extent that a business has to take up time collecting, or worrying about uncollected bills, the factor offers a reduction in aggravation that may be worth the price of the premium.
"Cash flow is king, and it's the factors that give you the cash flow," says Larry Rosenblum, CFO of the magazine Nylon, which uses factoring to speed up the process of earning income off its advertisers. "The banks are concerned with the credit quality of their debtor, the small business. But the factor does credit checking on the people who owe you money--and then it takes the collection role as well. Factoring looks expensive, but all these other services are provided."
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.
Factors also won't necessarily advance money for all customers' invoices. The factor can select from just those it believes are most likely to pay up. And just in case the bills don't get paid, factors may also insist on a blanket lien on whatever hard assets a company does have.
Factors also want to know all about a business to which they're advancing money. "You don't want to take on a client who has a million in sales and then a million in returns," says Fox, the CEO of Rockland Credit Finance. In many situations, the factor will insist on "recourse"--the right to sell the invoice back to you at face value if the debt goes unpaid beyond, say, 90 days.
Discount rates may be much higher on so-called "nonrecourse" paper, where the factor is simply out of pocket if your customer welshes. As good a deal as that sounds, there are advantages in giving the factor recourse against an unpaid bill. At least then, a company can control the factor's dunning tactics, and possibly save a customer who could be lost forever if the factor pushes too hard.
Everything is negotiable when it comes to terms. The better the experience a factor continues to have with a customer, the better that customer's future rates will be. Some businesses still worry about bad publicity from using a factor. It's often the case that companies won't turn to factors until they've exhausted their line of credit at the bank.
But the reverse can also be true: Companies may also wish to get the easier money factors offer rather than face getting the cold shoulder at the bank. "A lot of small businessmen take it personally if they get turned down for a bank loan," says Leonard Leff, president of CDS Capital, a finance and factoring company in Lynbrook, N.Y. "They say, 'Do I want to get another rejection?' and they don't ask their bank for the loan."
The latest wave of services that factors offer is making them all but irresistible to many businesses. No files, no filing cabinets, no warehouse space for paper records.
Even today, many company owners who use factors don't much like to talk about it, except to assure the questioner that their relations with their banks are just terrific. Still, the latest wave of services that factors offer is making them all but irresistible to many businesses. Choung's factor, Leff of CDS Capital, is on the leading edge of firms offering these new services. On an average day, CDS processes about a million transactions and has about $375 million in outstanding credit.
Choung is a typical CDS client. He never actually sends or collects bills from his dry-cleaning customers: All billing and collecting is done by CDS, which keeps its clients' books showing cash position and cash received every day, bills paid, and accounts still receivable. The information is always available to Choung, in encrypted form, on CDS's website. Choung can download documents when he wants copies. Otherwise, there are no files, no filing cabinets, no warehouse space for paper records.
Lloyd Bernstein, whose Oyster Bay, N.Y., hardware store, called Bernstein's Home Center, has been in his family 82 years, originally used CDS only for its billing services; he only later moved on to the company's factor offerings. "At first glance," he says, "you think it must cost more, but the costs are probably about the same. We'd have 80 to 100 small checks a day, and the bank charges you to deposit those. There's no postage and mailing. I was able to cut my office staff by two people."
By using factoring, Leff argues, "the hardware store can compete against Home Depot and the local pharmacy can compete against Duane Reade. They can't do it themselves, because they simply don't have the cash. Every time you take on a new account, you need more money, and the banks don't understand the problem." As to the cost, Leff argues it can be worth it. "Of course, it's expensive," he says. "You've got $500,000 in bills and you pay us $15,000; that's a lot of money. But the question is, what do you use the rest of the money for? Most of our clients use it to expand their business."
Leff's business is a story in itself, one that very well may presage the future of the factoring business. He originally developed his services from experience as an outsourcer for billing. The 42-year-old is the son of a computer operator at Harvey Electronics, one of New York City's premier dealers in fancy audio-visual equipment. In 1972, to supplement his income, Leff's father, Arnold, offered to prepare and mail bills for pharmacies in the suburb where he lived. Harvey Electronics had recently installed an IBM mainframe to do its own billing and bookkeeping and had more capacity than was needed. Leff's father arranged to use the Harvey computers when the store didn't need them.
The business grew, operating partly at Harvey Electronics and partly in the Leff family garage, and the whole family chipped in. When Arnold Leff died, his 14-year-old son, Leonard, helped his mother keep the business going. "IBM gave us some free consulting services," Leff remembers with gratitude, "and our customers financed our expansion."
Leff went to a local college, but he kept working at the billing business. "You could see that losses were never an issue: People paid their bills." Since pharmacists are always tight for cash, Leff occasionally offered to collect as well as pay their bills, advancing them the money when the bills were sent and charging them a fee for the service. Leff's company became, in effect, an accidental factor.
Hardware stores were next, with chain operations like True Value eager to have a service that would give their members cash to maintain their inventory without burdening their suppliers. Because they could offer their customers credit, and keep their shelves well stocked, smaller stores themselves found it less difficult (it still isn't easy) to compete against Home Depot and other big box retailers. So far as the customers of these stores know, they have a charge account with the store itself, and a credit relationship is always a source of loyalty.
What actually happens when the customer charges a purchase at one of these stores? A clerk punches in the customer's identity and the details of the sale. The message goes to a printer in the store, which generates a record for the customer and the retailer. At the close of the day, an electronic message is sent to Leff's computers, along with all the other transactions of the day. Leff deducts his 2 to 3% discount, and usually enough to maintain the roughly 20% reserve, then transmits the rest to the store's bank account.
If the invoice goes unpaid past the due date, one of Leff's dozen former bank credit analysts may talk with the business owner about ways to collect the money. Any bill that isn't paid after 90 days will be spit out of the computer and the money deducted from the store's reserve account. When customers are slower paying than Leff expected, he may charge the store a greater discount than 3%; if the bills are paid more quickly, the store can get a better deal.
The bills the customers receive at the end of the month are generated not at the store (even though it may look exactly that way because the bills feature each store's logo) but in the CDS offices in Lynbrook. The P.O. box to which the payments are sent is classic "lockboxes" emptied by CDS, not by the store the customer thinks has sent the bill.
Leff also offers his clients a credit card, which looks like a charge account from the customer's point of view but feeds directly into CDS. Though his billing business is now ancillary to the financial business, Leff still attracts many customers strictly for the CDS billing service.
The CDS computers keep track of the aging of invoices from every client, plus information from other sources, and produce an internal report Leff calls the "Daily Flash." This starts with a snapshot of the firm's position at the close of business the day before, adds some generally available economic statistics, and analyzes changes that might impact on credit. Based on the Daily Flash, Leff and his credit officers may impose credit freezes on a store's customers, increase or reduce a customer's credit line, or take other action.
The seal of approval of his product, Leff feels, was the recent decision by Staples to make CDS the exclusive provider of credit to its online customers. This recognition has fed Leff's ambition. "In the future," he says, "I want the small-business community to think, I get my payroll from ADP, I get my insurance from Hartford, and I get my billing and accounts-receivable analysis from CDS."
The factors listed below are all members of the Commercial Finance Association, the major trade group for the industry. It doesn't include every local factor or specialized factors, such as UPS.
Access Capital Inc.
New York City
Accord Financial Corp.
Action Capital Corp.
Advantage Funding Corp.
AeroFund Financial Inc.
San Jose, Calif.
Culver City, Calif.
(310) 410-9281 ext. 310
Allied Financial Corp.
American Commercial Finance Corp.
W. Hartford, Conn.
(800) 970-9997 ext. 11
AmeriSource Funding Inc.
Bank of America Commercial Finance
Bay Business Credit
Walnut Creek, Calif.
Bay View Funding
San Mateo, Calif.
BB&T Factors Corp.
High Point, N.C.
(336) 889-3355 ext. 200
BeneFactor Funding Corp.
Boston Financial & Equity Corp.
The Bradley Factor Inc.
Briar Capital LP
(832) 251-1500 ext. 223
Brookridge Funding Corp.
Business Alliance Capital Corp.
Capital Factors Inc.
Fort Lauderdale, Fla.
(561) 368-5011 ext. 2009
Capitol Resource Funding, Inc.
CDS Capital LLC
CIB Marine Commercial Finance, LLC
New York City
Commerce Funding Corp.
(703) 893-2150 ext. 233
Commercial Capital Lending, LLC
Baton Rouge, La.
The Commercial Finance Group
Community Business Finance Inc.
Congress Financial Corp.
New York City
Continental Business Credit Inc.
Woodland Hills, Calif.
Creative Capital Corp.
(248) 740-0700 ext. 600
DCD Capital LLC
New York City
Dimmitt & Owens Financial Inc.
Diversified Lenders Inc.
Entrepreneur Growth Capital
New York City
Spring Lake, N.J.
Evergreen Funding Corp.
First Capital Corp.
First Community Financial Corp.
Frost Capital Group
GE Capital Commercial Finance Inc.
Gibraltar Financial Corp.
GMAC Commercial Finance - Commercial Services Division
Goodman Factors Ltd.
Greenfield Commercial Credit LLC
Bloomfield Hills, Mich.
Gulf Coast Business Credit
Hennessey Capital LLC
Huntington Woods, Mich.
(248) 658-1100 ext. 201
HSBC Business Credit (USA) Inc.
New York City
IBM Global Financing
IIG Capital LLC
New York City
JD Factors LLC
Redondo Beach, Calif.
KBK Capital Corp.
LSQ Funding Group LC
Mazon Associates Inc.
Medical Capital Corp.
Mercantile Capital LLC
Merchant Factors Corp.
New York City
Metro Financial Services
Milberg Factors Inc.
New York City
Morrison Financial Services Ltd.
Pearce Financial Group Inc.
Coral Gables, Fla.
Platinum Funding Corp.
New York City
Porter Capital Corp.
Prestige Capital Corp.
Fort Lee, N.J.
Primary Funding Corp.
Prime Business Credit Inc.
Production Finance International LLC
Provident Financial Inc.
Puritan Finance Corp.
Redondo Beach, Calif.
Rockland Credit Finance LLC
Owings Mills, Md.
(410) 902-0393 ext. 103
Rosenthal & Rosenthal Inc.
New York City
Royal Bank Asset Based Finance
J.F. Simms & Co.
Southeastern Commercial Finance LLC
Spectrum Financial Corp.
W. Palm Beach, Fla.
(561) 833-7006 ext. 105
Stearns Financial Services
Woods Cross, Utah
Sterling Bancorp/ Sterling National Bank
New York City
Summit Financial Resources LP
Salt Lake City
Textron Financial Corp.
Transcap Trade Finance LLC
New York City
Transportation Alliance Bank, Inc.
United Capital Funding Corp.
St. Petersburg, Fla.
UPS Capital Corp.
USA Funding Ltd.
Venture Finance PLC
W. Sussex, U.K.
Vertex Financial Corp.
(214) 368-5881 ext. 15
Wells Fargo Century
New York City
Westgate Financial Corp.
Winston Financial Group Inc.
Santa Ana, Calif.
Yale Capital, Inc.
New York City
Martin Mayer is the author of more than two dozen books, including The Bankers and The Bankers: The Next Generation. He has been writing about banking for more than 40 years.