Getting a factoring line if you already have financing in place is difficult. Factoring companies can finance your invoices only after they secure a first UCC position on your accounts receivables. This requirement often conflicts with your current lender’s collateral position. This article explains how loans and factoring lines are secured and provides the criteria to be met before combining solutions. We cover:
- How do business loans secure their position?
- How do factoring companies secure their position?
- Why is this a problem?
- Can a subordination help?
- A more important question
1. How are business loans secured?
Business loans, lines of credit, and cash advances are usually secured against business assets. These assets serve as collateral for the loan. The lender can foreclose the collateral if the client company defaults on its loan.
Lenders secure their position by filing a UCC lien with the secretary of state. The lien describes the business assets that act as collateral for the transaction. Most lenders secure their position by filing a lien against “all assets.” This lien includes any current or future assets of the business. Other lenders may be more specific and secure their position only against specific assets such as equipment or real estate.
The lien’s seniority is usually based on its position. The first lender to file has a first-position lien. In the event of default, they get paid before any lender in a later position. Having a first-position lien is essential to lenders. Liens in subsequent positions have a lesser chance of making the lender whole in the event of default.
2. How do factoring companies secure their position?
Most factoring transactions are structured as invoice sales rather than as loans. Your company sells the financial rights to the invoice to the factor in exchange for payment. Like other finance companies, the factor must secure its position by filing a UCC lien. At a minimum, the factoring company must have a first-position lien on the accounts receivable it is financing. This requirement may conflict with the incumbent lender’s existing lien.
3. Why is this a problem?
Most lenders want to secure their transactions with accounts receivable. This type of asset is seen as “near cash,” which is why they prefer it. The lender and the factoring company cannot have the first position simultaneously. Consequently, you usually can’t combine a loan with invoice factoring.
A factoring company cannot take a second UCC lien position (or later) on accounts receivable. This position would leave the factoring company open to losing money if the client’s company defaults. Let’s illustrate this problem with an example.
Assume that a company has a loan with the first position on all assets. Later, the company secures a factoring line which is secured against accounts receivable. The lender has the first position on all assets, while the factor has the second position on accounts receivable.
The company defaults on its loan, which causes the lender to foreclose on assets. The first-position lender would take all open receivables, including the advances the factor sent to the company. The factor can be paid only after the loan with the first lender has been satisfied. This situation will likely be solved only through litigation. Ultimately, the factoring company will be lucky if it can recover some of its funds.
4. Can a subordination help?
There are two ways to solve this challenge. The first option is to pay off the lender in the first position. That option enables the lender to release the liens and allows you to use factoring. This situation is uncommon.
The second solution is to ask the first lender to subordinate their position on accounts receivable to the factoring company. This subordination is done using an inter-creditor agreement between the lender and the factor. Getting a primary lender to agree to a subordination is very difficult. They have the safest position from a collateral perspective. What is their incentive to give that position up? There are two possible arguments.
You could try to convince the lender that the amount of collateral they hold far exceeds the value of the loan. This scenario is common for companies that use equipment financing. Some equipment finance lenders secure their position against all assets when financing equipment. You may be able to convince them that they are over-collateralized and to release your A/R from their UCC lien.
A second strategy is to attempt to show the lender that a factoring line will help your company. In the long term, this approach will also help the lender by ensuring your company remains solvent and can capitalize on growth opportunities. Unfortunately, this is a weak argument with several assumptions. In our experience, using this argument to convince the lender seldom works.
5. A more important question
Consider a more important question: why does your company need factoring if it already has financing in place? Here are three possible answers. The company has:
- Outgrown the original loan
- A loan that was not correctly sized
- Problems that need additional financing
The first two options may be solved by refinancing the existing debt. This solution pays off the incumbent facility and replaces it with a new facility that meets your requirements.
The last option is the most common one, unfortunately. Companies request a factoring line because the company has financial problems, and the existing line is tapped out. There is no easy way to solve this problem. Consider speaking with a CPA or an expert in debt restructuring.