Dear Professor Bruce: I'm a small-business owner and am finding it difficult to get a bank loan. I've heard of something called factoring. What is it and when is it time to consider alternatives to traditional bank loans?
Answer: As the credit crisis spurs traditional lenders to tighten credit standards and raise fees, more small-business owners and entrepreneurs are seeking other ways to start a business or keep it going.
Small growth-oriented businesses and established mid-sized companies often require additional working capital when money is tied up in accounts receivable. Meanwhile, obtaining funding from banks and other traditional resources means a long and arduous process.
Furthermore, how many times have business owners heard that the check's in the mail?
Even when dealing with household corporate names, delayed payments are surprisingly common as head offices decide contractors or vendors can wait another 30, 60, or even 90 days.
It turns out companies that provide interim financing to these struggling small-business owners by purchasing their creditworthy, outstanding invoices — minus a fee — comprise a thriving, if little-known, global industry.
It's called factoring and it's worth an estimated $1 trillion a year worldwide, with $100 billion of that in the United States and about $4 billion in Canada, according to Factors Chain International, a global network of leading factoring companies.
According to Brian Birnbaum, one of the founders of Liquid Capital, "factoring is the purchase of corporate accounts receivable. It's generally used when a company is in its infancy or experiences a growth spurt and gives that company access to capital through non-traditional means".
A factor purchases a business's accounts receivable and gives them a large percentage of the total creditworthy accounts receivable up front. The remainder comes when they are collected.
The factor handles all the credit checks, collects the accounts receivable and ledgers the receivable so the client is able to concentrate on growing the business.
Factoring differs from traditional bank loans because the credit decision is strictly based on receivables, rather than other criteria, for instance, how long the company has been in business, working capital and personal credit score.
Factoring differs from equity financing in that factors don't take equity in the company. Since contracts are short-term, the client could elect to stop factoring whenever he or she chooses.
The industry, notes Birnbaum, is set to grow again in light of current instability in U.S. markets related to credit lending practices among major lenders, such as banks. Factoring does well when banks tighten their lending and people can't find money anywhere else.
Bruce Freeman is president of ProLine Communications, a marketing and public relations firm.