Some types of debt can be difficult to fund through factoring or invoice discounting. This can be as a result of either the debt's nature, or to circumstances which will affect a factor's ability to collect in the debts to repay their lending in the event that the business fails.
The main difficulties here come in respect of contractual debt for the provision of a service over a long period involving stage payments. Engineering contracts for capital equipment are an example, where a payment of a third with order, a third on delivery, and a third on commissioning is not unusual.
Contractual debt is always difficult to factor since if the supplier fails part way through delivery of a contract, its customer will normally seek to offset the costs of replacing the supplier and any associated disruption costs (which particularly in the construction industry can be quite creative), against the debt outstanding.
Construction contracts which will often run for many months or even years, involving a series of stage payments are another particular problem area as they are normally based on a process of 'applications' rather than invoices for a definitive amount. Under this system the builder raises an application for payment based on their estimates of the value of the job completed to date which then has to be agreed by the customer's architect or surveyors before the final agreed sum becomes payable, normally within two weeks. The bulk of a construction company's 'debtor' book therefore usually consists of applications which will turn into a debt, but where the value of the debt is uncertain until shortly before it is paid over.
There are only a limited number of factors who will provide funding against this type of debt and this is usually at lower levels of advance (say 50% against a more normal level of 75% to 85%, together with a requirement for personal guarantees) as they have less certainty as to both the collectability of any debt and in the case of applications, its actual real value.
Some ongoing contracts, for example for the supply of materials to a manufacturer for use on its production line, may include 'liquidated damage' clauses. They are intended to provide a mechanism whereby the customer can be compensated at an agreed rate for any interruption its production suffers if your business fails to supply it with widgets as agreed. These clauses create an issue for funders as should your business ever fail, they give rise to the basis for your customers to offset a claim for these damages against the sums due to you on which a factor has lent.
Sales which require extensive after sales service or warranties (such as bespoke computer software) may not be fundable, as again the customer may seek to offset a claim relating to the loss of this support or the costs of replacing it against any debt due which the factor would be looking to collect.
Sales to overseas customers can be a problem as the factor's ability and cost to collect will obviously vary from country to country. Some factors are members of international groups and are therefore able to consider funding ledgers with a relatively high degree of international exposure (of say up to 50%), although even here this will involve an assessment of the spread of the ledger on a region by region or country by country basis. Most of the independent sector is however focused on UK based debt only.
Sales to a single or very low numbers of customer can lead to a problem with what is known as 'concentration'. To avoid having all their eggs in one (or very few) baskets, factors generally like to see their risk spread across a number of debtors with any individual customer making up no more that 20% to 25% of the borrower's debtor book as in the opening case study. However this is an area where factors differ greatly in their policies and some will fund 'single debtor' clients. Otherwise in these situations the lender may allow temporary overpayments but these will usually come at an additional cost.
The level of advance that you can expect will vary from lender to lender but in general the banks' factoring arms have a high degree of captive business introduced through their banking colleagues and therefore tend to be more conservative than the independents.
As a very rough guide, you might expect a bank-owned factor to advance say 60% to 85% against a normal book, whilst the independent firms may range between 75% to 90%, and will in addition consider providing top up facilities against stock or agreed temporary overpayments of say up to 100% to cover specific items such as a peak requirements at a VAT quarter or exit penalties imposed by another lender.
It is important to realise that these percentage advances should be regarded as the 'nominal' level of advance. Any funder will only advance against 'approved' debt and this means the total of your debtors less the balances disallowed as a result of aging, when normally any debt of over 90 days old will be disallowed; and reserves set against the accounts to deal with any:
- supplier contras;
- balances in excess of agreed concentration limits;
- intercompany trading; or
- individual debtors that the lender won't fund for whatever reason, such as overseas debtors.
As a result of this disallowed debt, what really matters is your 'effective' advance, which is to say the funds available that you can actually draw down from the factor (your 'availability'), as a percentage of your total debtor book. As you can see from the potential reserves that will be applied above, this will often be significantly lower than the headline percentage advance you have agreed with the lender.
As discussed in the next article, this application of reserves to your account can be a particular issue if your business gets into difficulty.
So, before talking to a factor or invoice discounter, take a good look at your debtor book and the terms on which you are trading with customers. How much of your debtor book is realistically going to be fundable by a factor or invoice discounter and what issues might they face if they had to collect in debt if your business failed? The more you can address this up-front, the better the funding deal you are likely to be able to negotiate.