Summary: Finding a company that offers good factoring rates can be difficult. Several companies advertise seemingly cheap factoring rates. However, these rates often look “too good to be true.” In many cases, these factoring plans appear cheap but become very expensive once you read the fine print.
Finance companies are in a very competitive environment. There are factoring companies that offer excellent factoring terms without resorting to advertising gimmicks. This article shows you how to find and evaluate factoring companies. We cover:
- How much does factoring cost?
- Factoring terms
- How to evaluate factoring companies
- How to find a good company
1. How much does factoring really cost you?
Most business owners compare factoring companies by looking at the rate. This approach is straightforward but doesn’t work well for a couple of reasons. Most factors advertise low rates with advertisements such as “0.60% factoring rate.” These advertisements are attractive but don’t provide enough information for you to make an informed decision. This approach is misleading because the factoring rate is not the same as the factoring cost. The rate is merely one component of the total factoring cost.
The factoring cost is determined by combining:
- Factoring rate
- Advance rate
- Factoring period
- Ancillary fees (if any)
The simplest way to determine the actual cost is to use the concept of “total cost per dollar.” This method gives you a dollar cost (in cents) for every dollar you get from the factor. The “total cost per dollar” is also an effective tool to compare factoring offers. To calculate this cost, divide the rate by the advance.
Let’s look at the following scenario to show how rate alone can be deceptive. You receive two competing proposals with the following options. Which option is more expensive?
- 70% advance at 3.00% per 30 days
- 80% advance at 3.35% per 30 days
Some would argue that the second proposal is more expensive. After all, the rate is higher. However, you have to take into account that the second proposal also has a higher advance. A higher advance provides more funds upfront.
Actually, both proposals have a similar “cost per dollar.” In this example, both options have an approximate cost per dollar of $0.04. Let’s use the first proposal as an example. Divide the rate of 3% (0.03 in decimal) by the 70% advance (0.70 in decimal) to get four cents ($0.04 in decimal). Consequently, you pay roughly four cents every 30 days for each dollar that is advanced. For more information, learn how to compare factoring rates and proposals.
2. Understanding factoring contract terms
Unfortunately, finance contracts are complex. Some factoring companies that offer so-called “dirt-cheap prices” put some heavy demands in their contracts. Due to the complexity of finance contracts, business owners should consider getting qualified legal advice before engaging a factoring company.
Here is an overview of items that are common to most factoring contracts. The list is not all-inclusive, but it will help you better understand the terms.
a) Type of factoring
There are two types of factoring programs: with recourse and without recourse. In a recourse agreement, the factor can return any invoices if they are not paid within 90 days (varies). In a non-recourse agreement, factoring companies cannot return invoices that are not paid as long as the reason for non-payment is a customer-declared bankruptcy. Note that factoring companies can return any invoice that is not paid due to a dispute or a late payment. Ultimately, no financing option is perfect, and both types of financing have their advantages and disadvantages.
b) Contract length
Factoring agreements are usually valid for a specific period of time. This term can vary from 30 days up to a year or more. Contracts generally renew automatically unless the factor is duly notified.
There are advantages (e.g., discounts) and disadvantages to agreeing to a contractual period of time. However, you may not be able to leave the factoring company while the contract is in force without paying the penalty. Most companies are better off with an agreement that does not lock you in for a long period of time.
c) Factoring minimums
A factoring minimum is a commitment by your company to finance a certain amount of invoices. If your company does not finance the agreed-upon amount, your company must make up the difference in fees.
Note that not all factoring plans have minimums. Many factors offer “no-minimum” programs. Factors are often willing to offer discounts if you commit to a factoring minimum. You can use this offer to your advantage as long as you don’t commit to any minimums you can’t honor. In general, companies are better off when their contracts don’t have minimum terms.
d) Invoice processing fees
Some companies charge so-called “invoice processing fees.” Some factors add these charges to offset their “cheap” fees.
e) Mailing fees
Some factors charge a special fee whenever they have to mail documents to you. These fees can add up if you have a lot of paper correspondence with your factor.
f) Lockbox fees
A lockbox is a service provided by some banks and private companies. Lockboxes are used to receive, process, and deposit payments from your customers into the factor’s account. Some factors use a single lockbox for all their clients. Other factors get a specific lockbox for each client. Some factoring companies charge for this service, while others don’t.
g) Credit reviews
One of the most important services a factor provides is reviewing the creditworthiness of your clients. Most factors get credit reports in bulk and provide credit reviews as part of their services. However, some factors charge for each review. These charges can add up quickly.
h) Money transfer fees
Most factors charge you the cost of sending funds to clients using an ACH or a wire transfer. This fee is a common practice in the industry.
3. How to evaluate factoring companies
As a business owner, your objective is to work with a factoring company that is professional, reliable, and offers good terms. One way to find such a company is through referrals from colleagues in your industry who are already using a factoring company.
But what if none of your colleagues use factoring? How do you find a good finance company and avoid one that is “less than forthright”? Here are some points to help you evaluate the factoring company:
a) How long have they been in business?
You want to work with a company that has been in business for a while. This stability can provide some assurance that the factoring company knows how to manage its business. Running a factoring company is not easy, and a poorly managed company should not survive more than a few years.
A five-year track record is the minimum you should consider. However, a longer track record is always preferred.
b) Do they have clients in your industry?
Most factors claim to be generalists. That is fine, and it works in many situations. However, many industries have specific billing and invoicing practices that must be followed. These industries include staffing, transportation, healthcare, and construction. In these cases, you want to work with a company that has a specialist unit. Otherwise, you could encounter problems. Additionally, a specialist is likely to give you better terms than a generalist.
c) Are their terms acceptable?
You want to work with a factoring company that openly discloses all its terms and costs. Ideally, you want a simple fee structure with as few line items as possible. Many factors offer straightforward terms that include the rate, advance, and funds transfer fee. Note that larger transactions are more complex and may have additional fees, such as due diligence, etc.
d) Do they offer good service?
Every factoring company promotes its service as being “second to none.” For the most part, ignore those statements. Everyone makes them. A better way to evaluate a factoring company is to ask them for references. It’s most effective to ask for a few client references that are specific to your industry. Interview the references carefully and speak to clients who have been with the factor for a while.
4. How to find a factoring company
If you don’t have colleagues who can refer you to a reputable factoring company, consider looking for one on the Internet. Unfortunately, many company owners search for as many companies as they can and blindly submit many applications. This strategy is counterproductive. Business owners who follow this strategy usually end up overwhelmed by offers and may not be able to manage all the paperwork. It’s better to follow a systematic approach that allows you to find the right company for you. Here are some tips:
a) Spend some time researching companies on the Internet
Look for companies on the Internet. Review their websites to determine if they are a good match for what your company needs. Use this search to build an initial list of candidates.
b) Select the top three or four firms that interest you
Narrow the list of candidates to the top three or four firms that interest you. Here are some criteria to consider:
- Do their plans match your needs?
- How long have they been in business?
- Do they work in your industry?
- Do their terms work for you?
- Do they require minimums?
c) Interview the companies
Call the top three or four companies and interview them. Ask as many questions as possible. It’s essential to ask them questions specific to your industry to determine if they are knowledgeable.
d) Submit a couple of applications
Select no more than two companies and submit applications to get a better idea of what they offer. The factoring company will review the application and eventually provide a proposal.
5. Evaluate proposals and check references
Evaluate the factoring company’s proposals as we discussed earlier in the article. Additionally, check the factor’s references. Use this information and select the best factoring company for your business.
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