Invoice factoring is a type of working capital facility used by over 42,000 businesses in the UK according to the Asset Based Finance Association (ABFA). For the vast majority it is a valuable source of working capital that helps smooth their cashflow. However, I do hear the odd horror story and as such thought that I should talk about some of the pitfalls that can occur and how best to avoid them or deal with them.
Invoice factoring companies have to limit their risk so that they do not lose money and as such only certain types of debt are suitable for factoring. They also set certain parameters for the facility that are monitored on an ongoing basis. Importantly most , not all, factoring comanies will sign clients up for a 12 month contract period.
So let’s have a look at some of the more common pitfalls or complaints from clients.
Turnover has dropped and as such the factoring minimum fees are coming into effect and proving expensive. It is important you have a grip on what your turnover will be but I accept that crystal balls are hard to come by. Turnover is a major variable when calculating fees and typically the larger the turnover the lower the percentage service fee paid. To prevent a business forecasting a £10m turnover and the associated pricing but actually producing a turnover of £300,000 the invoice factoring company will implement a minimum fee. Unfortunately if a business loses a major customer or the market moves against them turnover can drop dramatically and the minimum fees can prove expensive. In this instance it may be possible to renegotiate with the lender for an increased percentage service fee but lower minimum fees based on the new turnover levels. In essence you are asking them to reprice based on the new variables of the business.
Concentration limits are proving restrictive – one of the parameters I mentioned above is a concentration limit. This is the percentage of your ledger that is outstanding from a single debtor. Some lenders restrict this to 20% while others are perfectly happy to provide funding against a single debtor. It is imperative that this is understood from the outset. Obviously your ledger can change over time so it is important to flag any issues in to your factoring company early on. Unfortunately they are not always accomodating. I recently experienced an issue with Venture Finance where a scaffolding client of mine won a large contract and anticipated a concentration issue for the coming months. He approached Venture Finance who took over 3 months for any kind of a response. As a result my client has tendered his termination.
Debtor Limits are Restrictive – it is important to remember that invoice factoring companies want to lend money but they have to assess the credit worthiness of your customers and set credit limits accordingly. If you have an order from a customer who is not credit worthy it may be tempting to deal with them. However, the advice offered by your factoring company may well limit your risk of bad debts. These limits can of course change over time and as a result credit limits can be reduced in some instances. This can mean that by dealing with some customers you are not receiving the funding that you may have expected. It is important to look at the credit limit of any customer prior to accepting an order. It is also important to have a lender that responds quickly to credit limit requests.
Early termination fees – I hear a lot of complaints about early termination fees and I have to say in some instances I do see excessive ones. Lenders will typically look to recover the fees they would have earned until the end of your contract and as such these can be hefty! The key is to set up a facility that works from the outset. Do your research, understand the fees and how the factoring facility operates. If you are looking to leave because the facility doesn’t work there may be room for negotiation but if you are looking to move to an alternative provider for reduced fees it is unlikely to be viable.
Collect Out Fees – in the event of business failure a lender will collect out what they are owed from your customer base. They will do this as quickly as they can to minimise the risk of bad debt and this is good for business owners as they will usually be supporting by way of a personal guarantee. The lender will levy a charge for this and it is usually a percentage of the ledger value. This can be a substantial sum as high as 15-20%. I have seen some lenders charge this fee even when they had no money advanced to the business at all. In part this fee can be justified but is often excessive in my opinion. However, it will have little impact on the directors or owners in most instances as it simply reduces the amount available to creditors. It rarely impacts on the business owners pocket. This does not make it right and the impact should always be considered.
As other pitfalls crop up I will add to this post.
The key is to arrange a facility properly from the outset and understand what parameters/conditions are in place and why. Understand how they can impact on the funds generated and on your business.
As an invoice finance broker I am always available to answer questions and assist where possible.
