When that factoring or invoice discounting offer letter hits your doormat or your e-mail account, it may seem that the answer to your cash flow worries has finally arrived. However, in a very competitive market, with more than 90 (very different) providers of receivables finance, it is more important than ever to look beyond the headline figures on your offer letter.
First, before examining the detail of the offer letter, a golden rule. If you have only one offer on the table, get another one. It is far too easy, especially as a first-time buyer, to take the path of least resistance and sign up with your clearing bank factor. Depending on your requirements, this might be an appropriate choice. However, talk to your suppliers and customers and find out who they use.
Get as much feedback as possible from people using factoring or invoice discounting before going ahead. Getting into a relationship with the wrong provider of finance (clearing bank or independent), as we will discover, could mean the start of a very unhappy funding relationship.
An offer letter should ideally cover the following four points:
1, the level of funding;
2, the cost of the facility;
3, the security requirements; and
4, the termination conditions.
Offer letters are not standard and there can be vast differences in the amount of information given about the above points. So it is important that an informed decision can be made on a like for like basis when comparing offer letters. Probably the most important figure for any potential client of a factoring or invoice discounting company is the prepayment level - the amount of money you will receive against your sales ledger. It is very easy to quote in an offer letter that funding will be up to 85% to 90% of approved debtors. But the real level of funding will also vary according to credit limits, concentration limits, refer limits, export accounts and recourse periods.
The aforementioned limitations should appear in the offer letter, although it is also useful to clarify how operational considerations such as the verification levels required of invoices, treatment of contra accounts, a delay in providing proof of deliveries as well as a disputed invoice would affect the level of funding provided.
It is very important to understand how any restrictions are applied or managed within a facility as at some point during the facility you will need to rely on the flexibility of your lender. This may come in the form of an overpayment against your approved debtor figure to meet wage payment or your client manager looking at the payment history you have with a debtor rather than the credit limit that the computer throws out.
Unfortunately, the deciding factor for many first time buyers of receivables finance is the cost of the facility. While the cost should always be an important consideration, what you get for your money is even more important. If you have never used factoring or invoice discounting before, the two most important costs with which you will be presented are the discount charge and the service fee.
Discount charge
The discount charge is the easiest figure of an offer letter to compare, as it is simply the interest charged on the money borrowed against the facility. It is normally expressed as a percentage over a clearing bank base borrowing rate. It is always worth confirming that the bank base borrowing rate is not subject to a minimum which may be higher than the Bank of England base rate.
Service fee
The service fee for factoring relates to the charge for managing the sales ledger and essentially is calculated on the projected workload on the account - the number of customers, number of invoices, level of credit and debit notes and so on. The service fee for invoice discounting is the cost of providing the facility - access to funding against your outstanding invoices. Both service fees are typically charged as a percentage of gross turnover (including VAT) and normally underpinned by a minimum annual service charge which may be applied if projected turnover levels are not met.
Other charges
The other charges that will affect the overall cost of the facility and so need to be considered when comparing offers are as follows. Re-factoring charges are generally applied when the debt ages past the agreed recourse period. This charge is normally applied as a percentage of the value of debt assigned and charged monthly until the debt is repaid. This may also limit funding as the aged amount may be recovered from current availability.
Transactional charges also need to be considered, for example, the cost of requesting a BACS or CHAPS payment from a lender will vary, as will the level of trust account charges applied for monies received into a trust account. An important charge that is sometimes overlooked, especially if the borrowing level is high, are the number of clearing days taken before debtor funds are applied to credit balances, as the discount charge will continue to be charged for this period.
At take-on of the debts, at the start of the facility, the service fee will normally be charged as a percentage of the balance taken on. There may also be a one-off arrangement fee and most lenders will charge a documentation fee. Many lenders will also require some form of audit during the course of the facility and it should be clarified if this is included as part of the service fee or if it is an additional charge.
Security requirements will vary greatly between lenders and can often be a deciding factor for an owner-manager on which lender they choose. If available, the majority of lenders will take an all asset debenture over the company or, as minimum, will insist on a waiver from any other lenders over the book debts.
Personal security from the directors may also be required to support the facility and this is standard if there has been a previous failure or if the financials of the business are particularly weak. Depending on the perceived risk of the lender then this may need to be supported by way of a second charge on a property or by taking security over other assets. If a formal or limited personal guarantee is not available then a lender will look for an indemnity or warranty which essentially entitles them to enforce a personal guarantee if there has been a breach of the agreement due to fraud.
The last area of an offer letter probably needs as much consideration as all the others together. For a first-time buyer the terms for termination of a facility are very important and often overlooked in the rush to sign-up. Most agreements will be for a minimum of 12 months with a three to six month notice period.
So once you start a facility it is foreseeable that you may be locked in anywhere from 15 to 18 months. This is fine if you are satisfied with the facility and things are running smoothly, but what if things are not? It may be difficult to leave before the agreed period without paying the annual minimum charge. It is important to read the factoring agreement as some may mean that if notice is not given on the anniversary of the agreement then the lender is entitled to another year's annual minimum fee.
The market for factoring and invoice discounting is becoming increasingly competitive. Offer letters are not standard and will all be presented in slightly different ways. Comparing invoice discounting offers is easier than factoring ones as facilities are becoming more commoditised and driven by price. For factoring offers, choosing who will be chasing your sales ledger has to be taken into consideration as well as understanding the mechanics of the funding being offered, the security required and the termination period.
It is important to remember that the offer letter should help you make your decision or shortlist a potential number of providers. Once a shortlist of funders has been arrived at, it is always worth talking to some of their existing clients and asking about flexibility and service levels. If all things seem equal between several offer letters, it is a good idea to visit the lender's offices and meet the operations team who will be running your account once the salesperson has finished their job.
Remember, once you have signed the offer letter there will normally still have to be due diligence undertaken before the formal offer is made and the facility starts. More and more lenders require a commitment fee to move forward to this stage, which should be refundable if there is a material change in the formal offer from the in-principle offer.
If you are happy with the final offer, legal agreements can be signed. But remember that the legal agreement always prevails over the offer letter and, as with most legal agreements, the devil is always in the detail.