Invoice factoring is one popular way to get a loan for businesses that need money asap. For a small company, you might not have enough finances to take on new projects until your clients pay for the previous ones. Factoring agreements are an easy, accessible, and fast way to get cash to run your enterprise or get on with a project.
A factoring agreement is a contract between a company and a factoring enterprise, showing a sale of receivables for instant funds. Like any contract, you need to know what you are getting yourself into, especially regarding money and your company’s survival.
Here is what to look out for before signing the factoring contract:
Types of Factoring Agreements
There are two types:
Your company is liable for any unpaid invoice in a recourse agreement. You will have to buy back the accounts receivables and pay the debt or give other invoices matching the loan.
If the invoices are not paid in non-recourse factoring, your company will not be liable. However, you will pay higher fees than the recourse one.
Components of A Factoring Agreement
1. Draw Up Fee
The factoring fee is the first payment you will make to the Factor. The company will cut a percentage from the amount you are to receive. The fee varies from one company to another and is dependent on factors such as; your customers’ creditworthiness, industry, invoice value, location, and reliability of your customers.
2. Advance Rate
The amount you will receive will also be indicated on the factoring agreement. It will also show the company’s rate, usually between 70-80%.
3. Early Termination
Factoring contracts will outline the amount of time you need to notify the factoring company on your wanting to terminate your agreement. It will also state the fee you need to pay for the termination.
4. Customer Limit
The debtor limit is the maximum amount each customer’s invoice is supposed to pay the Factor. Each customer is different, so the loan repayment is spread out accordingly. It would be risky to tie the repayment to one client, and they defaulted.
5. Notice of Assignment
You need to notify your customers that they will be making payments to the factor company instead of yours. The notice should include factoring agreement terms on how to make payments. The Factor will also send an acknowledgment letter to them, which they must sign to confirm that they are okay with the changes.
If a customer makes a payment to your company, you must send it to the invoice factoring company.
6. Customer approval
The Factor company will research all your clients to vet their creditworthiness. Before they do this, it would be advisable to discuss it with your customers so that they are not caught off guard and refuse to go through the process.
If any issues arise between you and your client, the Factor will give you time to settle the dispute.
7. Maintenance fees
Another fee you will be required to pay is the maintenance fee done weekly or monthly. The payment period is dependent on the contract and company.
The factoring company will ask for collateral for security purposes if the invoices go unpaid. Some items that can be used as a guarantee are; property, equipment, and inventory.
9. Invoice List
You may not want to sell all your account receivables. The contract should also include the list of invoices that you want the factoring company to use.
How to Avoid Making Factoring Agreement Mistakes
1. Read the factoring agreement thoroughly
When you do not read the entire contract and peruse through, that is where you will start making mistakes.
Why is it important to read your factoring agreement? You are legally bound to it once you put your signature on that paper. A lot of people skip through reading every detail because of its length. However, as a business, you need to read to know:
- What your role will be and that of the Factor
- Rules you are required to follow
- Penalties of defaulting the factoring agreement
You need to understand everything that is written, and not all factoring companies are similar. If you need a lawyer to clarify anything, go ahead and get one. You can also ask someone you trust to go through to ensure you do not miss anything.
You have the opportunity to ask the factoring company questions on what is not clear, especially concerning added fees. You can also negotiate and customize the contract to fit you at this point if the Factor is flexible.
Imagine receiving a notice on unpaid factoring fees that you were unaware of because you did not read the contract? What’s worse, they can sue you for defaulting and could cost your business so much more.
2. Factoring Company’s Culture
Another mistake would be to give a factoring company with poor relation techniques access to your customers. Remember, whatever they do represents you, so you have to do your due diligence.
Because they will be in charge of following up on payments from clients, please find out how the company does it. If their methods sit well with you, you can put down your signature.
3. Not Considering The Time Lines
When you are making plans on using the loan, take note of how long the invoice factoring process takes. Factoring companies take time to approve the loan as they do their due diligence, so you will not receive the money until they are satisfied.
4. Not Invoicing
It might seem obvious, but it’s common for companies to forget to send invoices to their customers. As the Factor is waiting for payment, the debtor has no idea of any due payment.
5. Misdirecting payments
Customers should make all payments to the factoring company. If you fail to communicate this to your customers, you will send the money instead. It could lead to friction between you and the Factor and lead to termination of the agreement and penalties.
Is Factoring Invoices A Good Idea?
There are benefits to selling your invoices for cash upfront. They include:
Helps in running the business
Every business needs working capital to run its day-to-day activities such as buying inventory, making deliveries, and marketing. It can also go to investing in expansion projects. Unfortunately, you might find that most of the money you would use for this is tied up in debtors.
Factoring invoices allows you to sell those accounts receivables and get money to achieve your obligations and plans.
It is easier to get a loan through factoring invoices even when you have a bad credit score. The Factor is mainly interested in the creditworthiness of your customers more than they are in yours.
The process involves the Factor doing research on your clients on their creditworthiness. It will give you insight into what kind of customer you have. If they are likely to default, you will be keen to have them pay outstanding bills and have them pay in advance in the future.
You would not know of this if it was not for the factoring company doing a thorough credit check on them.
Additional Support Services
Besides the cash flow assistance, your company gets other supporting services such as credit checks, credit collection, and receivable reports. The Factor also does intense research in your industry before deciding whether or not to give you the loan.
In that regard, they will give you advice on what they learn from it, which will help you know what changes to make. Their advice will also help you know what opportunities to take up as you grow your business.
The cons to factoring agreements include:
Reduction of Profit
Your company loses some profit through the fees you have to pay to get the money upfront. If you did not have to sell the invoices, you would receive the full value.
You lose control over your customer relationship when it comes to debt collection. Some customers are not comfortable with another company getting involved in their finances. It might lead to your customer dropping off or changing the dynamics of your relationship.
Customer’s Credit Score
The Factor will base his decision to give you the loan based on your clients’ credit score. If they have a poor score, then they will not approve it.
Can you modify or terminate a factoring agreement?
You may have already entered an invoice factoring contract that you are unhappy with or have found another company with better terms. Yes, you can change your contract or terminate it if you want.
When making changes, get guidance from a factoring expert, lawyer, or accountant to get the best deal. Have a clear list of what amendments you want to the agreement. If you want to terminate the agreement, check on the termination fee and the notice period on the contract.
Most factoring companies are now more transparent on additional fees they charge and terms of the contracts. But even so, with the information provided in this article, you will be able to make a well-educated decision on your factoring agreement.
In addition, if you still have further questions concerning anything with factoring, we share with you these trusted formations services and registered agents services that can answer all your questions and help with the matter.
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