Much is written about venture capital, and bank borrowing gets a lot of press whenever private equity firms are mentioned. However, many people start businesses and self-finance them with no outside capital. Many use second mortgages or home equity lines of credit. When these self-financed companies hit a rocky patch they have no bank relationships to fall back on or are sufficiently unprofitable that a bank will not consider them for credit. Where do you go for financing when you can not get a bank loan? The answer is a factor.
Factors will buy your receivables, thereby providing financing for your company. Factors look principally to the quality of receivables, pay about 80 percent of the value of eligible receivables and are not too concerned about the quality of earnings, company history or other unpleasantness. They typically charge from about 18-25 percent per annum effective interest rate. (Calculating the effective interest rate can be quite challenging given the reserve requirements, fees, etc.) Obviously, for the higher risk they are getting a higher return.
Factoring is attractive when:
- You have insufficient company history to get a bank interested in a loan, such as in early stage companies
- You are not willing to give personal guarantees, which most banks require
- Your personal history (bankruptcies, tax liens, lawsuits, felony convictions) prevents you from securing a bank loan
- No bank will give you a loan
There are two principal drawbacks to factors:
- They typically will not advance any money against inventory
- They typically will not buy foreign receivables
While the cost of factoring is high I do not consider it a drawback. When you need financing, cost should be the last issue you consider. Many owners erroneously reject factoring because of the cost but it is typically more of an emotional rather than rational reaction. If you collect a receivable in 45 days the cost of factoring is about three percent of sales.
