What is Factoring?

As a startup owner, securing financing is likely a top priority. We tend to think of financing as long-term financing. That is, raising permanent equity capital or long-term debt. But short-term financing is another critical consideration. This is especially true for cash-strapped startups. Accordingly, factoring is a form of short-term financing that can help with cash flow challenges. Under a factoring agreement, you sell your trade receivables to a factor, which is a specialist financial firm. The factor then collects the receivables on your behalf, which it uses to pay itself back for the cash it advances you upfront. This article will examine what factoring is in more detail. 

What Are Trade Receivables?

All businesses generate sales, which refers to the cash they receive in exchange for the goods or services they provide. In practice, most businesses sell their goods or services to their customers on credit. This means the customer receives the goods or services before paying for them. The terms of credit depend on your industry and customer relationships. However, credit periods of 14 to 30 days are standard. 

Until your customer pays you back, you have a legal claim against the customer. This claim is an asset because it represents money the trade debtor owes you. Therefore, accountants treat this asset as a current asset because it is similar to cash in the sense that you can demand payment at the point it is due. 

However, in practice, there are trade receivables you are unlikely to recover from specific customers. Additionally, you will likely have your own suppliers that you need to pay (your trade creditors). Both raise problems since you may not have enough cash to meet your obligations despite your customers owing you money. 

How Does Factoring Help with Cash Flow?

A trade receivable is essentially a promise that your startup’s customers will pay you in the future. The law treats trade receivables as an asset. That is, you can buy and sell a trade receivable just like you can a piece of property or machinery. 

General financial management principles say that, in some cases, it is better to have cash now than the promise to receive cash in the future. This is particularly true when you are cash-strapped. As a result, there is a market where specialist financial institutions called factors will purchase your trade receivables upfront at a discount. This discount reflects their service by giving your startup cash now. 

What is the Difference Between Recourse and Non-Recourse Factoring? 

There are two main forms of factoring, including:

• recourse; and 
• non-recourse. 

Recourse factoring is where the factor assumes no responsibility for bad debts arising from the credit sales. On the other hand, non-recourse factoring refers to arrangements where the factor agrees to absorb any bad debts. 

For instance, say your startup has the following trade receivables due over the next eight weeks. Today’s date is 1 December 2023. 

FactorCo LLP may offer to purchase your startup’s next eight weeks of trade receivables under a factoring agreement. 

These trade receivables have a “book value” of £25,000. FactorCo offers you £21,250 up front, which reflects an 85% discount on the book value of the trade receivables. The discount reflects the fact that FactorCo is:

• essentially loaning you money on the basis that it can recover the loan; and
• discounting the book value of the trade receivables because it is concerned that at least one of the customers may not pay its invoice. 

Nevertheless, 85% may seem like a steep discount. Therefore, you should investigate other means of short-term financing, such as:

• overdraft facilities;
• invoice discounting; and 
• drawing from retained earnings.

What Are the Advantages and Disadvantages of Factoring? 

Factoring provides you with a ready-made solution for cash-flow challenges. This is because factoring frees up key personnel who otherwise may have to spend time chasing customers for payment.

Nevertheless, there are some disadvantages to factoring. Namely, factoring is:

• a relatively expensive form of short-term financing;
• usually only available for startups with sales of at least £50,000 a year; 
• can impair customer relations because the factor collects the invoice rather than your startup;
• an indication of financial distress to some suppliers and customers; 
• sometimes onerous depending on the terms of the factoring agreement; and
• not available for all startups due to the risk of dispute in particular industries, such as the construction industry.

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Key Takeaways 

Startups often face short-term financing challenges that impair cash flow. Nevertheless, factoring is a form of short-term financing that helps with cash flow by selling trade receivables to a financial firm called a factor. In this sense, factoring allows startups to receive cash upfront by selling these receivables at a discount. You should note that there are two types of factoring. One is recourse, where the factor assumes no responsibility for bad debts. The other is non-recourse factoring, where the factor absorbs bad debts. When deciding to use factoring, you should consider its high costs and potential negative perceptions from suppliers and customers.

If you need help with your startup’s financing, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.