Factoring is a financing method that is usually much more expensive than conventional bank financing. Yet it is an important option for small and medium-sized enterprises (SMEs) that may not have access to conventional bank financing, usually because of lack of appropriate credit history.

This article will first provide a definition of factoring, then discuss the circumstances in which factoring might be appropriate, and conclude with some pointers on types of structures for factoring agreements.

What is factoring?
I will use the Wikipedia definition of factoring: a financial transaction whereby a business sells its accounts receivable – invoices – to a third party, called a factor, at a discount in exchange for immediate money with which to finance continued business.

Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables, not the firm’s creditworthiness. Secondly, factoring is not a loan – it is the purchase of a financial asset, namely the receivable. Finally, a bank loan involves two parties, whereas factoring involves three.

When is it appropriate?
In most circumstances, where a bank can finance its receivables via conventional bank loan, this will be preferable, as a significantly less expensive form of financing. A revolving line of credit backed by receivables that is offered by a bank may have an interest cost that is a fraction of the discount applied by a factor.

However, where a business is a start-up and has insufficient credit history, or has developed a poor credit history, it may need to resort to factoring. This may be possible where its clients – the parties issuing the invoices – have strong credit history, hence the factor can look to the strong credit history of the clients to provide assurance of payment.

Given the generally higher cost of factoring, only businesses that are projected to be highly profitable and cash flow positive should consider factoring. In other words, if the business can generate a return on capital that is higher than the cost of capital, adjusted for risk, factoring may make sense. If an illiquid business resorts to factoring out of desperation, to provide some short-term liquidity, without the ability to generate a higher return than its cost of capital, it will only dig itself a deeper hole.

Given the general reluctance of banks to lend to SMEs in today’s environment unless there is relative strong security, like real estate or a personal guarantee, factoring may also be a way for a business to be self-standing in its financing, without resorting to collateral or guarantees.

What to look for?
There are many types of factoring agreements. Some of them are what I would call "classical" factoring agreements, where the factor literally buys the receivable at a discount and thus has no remedy against the business if there is a default on the receivables; and others that may be called factoring agreements in name, but in many ways resemble loans.

For example, one variation involves the factor advancing about 80 per cent of the invoice amount at the outset. The balance of 20 per cent is kept in a kind of notional reserve pool, paid out when the receivable is paid to the factor. Or if there is a default on the receivable, or more than 90 days goes by without payment, the factor may deduct it from the reserve pool.

The devil of any factoring agreement is in the details: what events constitute a default? What are the consequences of default? What are notice and cure provisions? Is there any minimum amount per month or quarter that must be factored? Most factors will insist on the receivables flowing directly from the client to them.

In conclusion, factoring is not appropriate for every SME. But in certain particular circumstances where bank financing is not available, or the owner wishes to avoid guarantees or collateral, and the business generates a return that is higher than the cost of capital, factoring may be a viable option worth of consideration.

* Les Nemethy is the CEO of Euro-Phoenix Financial Advisors Ltd. (www.europhoenix.com), a Central European corporate finance company focused on mergers and acquisitions. He is the author of Business Exit Planning, published by John Wiley & Sons and available on Amazon.