FREE CHAPTER from ‘A Practical Guide to Factoring and Invoice Financing’ by Karina Champion

CHAPTER ONE – FACTORING


THE TRADITIONAL MODEL

1-01    Factoring, in its traditional form, is a means by which a business (‘the Business’) is able to accelerate and optimise its cashflow by selling its accounts receivable (referred to variously as ‘invoices’ or ‘debts’ herein) to a factoring company (‘the Factor’) for a discounted price (i.e. for a price less than the face value of the relevant invoice).

1-02    Under the traditional factoring model, the Factor enters into a factoring agreement with the Business pursuant to which the Business assigns to the Factor the unpaid trade invoices it has raised (and will in due course raise) to its customers (‘the Customers’). Shortly after the assignment of each such invoice (usually between 1 and 3 working days), the Factor makes an advance payment to the Business (typically somewhere between 75-90% of the invoice value depending on what the parties have agreed), thereby giving the Business accelerated access to funds for which it would ordinarily have had to wait until the expiry of the payment term agreed with its Customer. So, where a Business has payment terms of 30 days from date of invoice, instead of having to wait for 30 days before receiving payment from its Customer, the Business may only have to wait a matter of days (or less than a day in some cases) before receiving the bulk of the funds due under the invoice.

1-03    Depending on the terms of the factoring facility, notice of the fact that the invoice has been assigned to the Factor by the Business is given to the Customer from whom payment is due (usually when the invoice is raised by means of a written notice printed or stamped on the invoice) and the Customer is informed that the Factor is now the owner of the invoice and payment of the invoice should be made to the Factor rather than the Business. As the assignee and now owner of the Business’s unpaid invoices, the Factor takes responsibility for collecting the monies due under the invoices from the Business’s Customers. On receipt of payment from those Customers, the Factor then credits the balance of the invoice value to the Business (having first deducted its fees and any other applicable charges).

1-04    The aforesaid process is beneficial for the Business because the Business receives a substantial tranche of the value of its invoice significantly earlier than the invoice falls due for payment from the Customer under the standard payment terms of the Business, thereby improving the Business’s cashflow and releasing funds with which to grow the Business. The Business is also able to outsource responsibility for its credit control to the Factor, thereby allowing it to focus on generating further trade.

1-05    The process is obviously beneficial to the Factor as well because the Factor receives the full value of the Business’s invoice by way of assignment but is only obliged to pay the Business an agreed proportion of the invoice value, thereby generating a profit.

VARIATIONS AND HYBRIDS

1-06    Not all factoring facilities operate in exactly the same way as the traditional model and it should be stressed that the process described above is only a basic sketch of the fundamental aspects of a traditional factoring facility. There are numerous different permutations of the traditional model such that it is difficult to provide an exhaustive list of all the various types of facilities which exist in modern commerce. As will be seen, this difficulty is compounded by the fact that the nomenclature used to describe different kinds of factoring facilities is not always used consistently, either by lawyers or by those working in the factoring industry.

1-07    It is perhaps useful to start by observing that almost all standard factoring facilities will either be ‘Recourse’ facilities or ‘Non-Recourse’ facilities. Equally, almost all standard facilities will either be ‘Disclosed’ facilities or ‘Undisclosed’ facilities.

Recourse

1-08    Recourse Factoring is so-called because it allows the Factor to have recourse to the Business in the event that the Customer doesn’t pay, or only part-pays, the invoice assigned to the Factor by the Business. If the Customer doesn’t pay the Factor or only part-pays the assigned invoice, or if the Customer becomes insolvent, recourse will usually be effected by the Factor requiring the Business to re-purchase the invoice (or so much of it as remains outstanding) from the Factor or by the Factor requiring the Business to indemnify the Factor in respect of non-payment by the Customer. In Recourse Factoring, the Business retains the risk of bad debts. It is for this reason that Recourse Factoring tends to be less expensive than other forms of factoring where it is the Factor, rather than the Business, who bears the majority of the risk of the Business’s Customers not paying the Business’s invoices.

Non-Recourse

1-09    In Non-recourse Factoring facilities, the Factor takes on the credit risk of the Customer not paying its debts to the Business. Save in certain circumstances (e.g. where there has been a breach of an undertaking or warranty[1] by the Business or where the debt is genuinely disputed by the Customer), the Factor does not have recourse to the Business if invoices are not paid by the Business’s Customers, whether by re-assigning them to the Business or seeking an indemnity from the Business in respect of bad debts. It is for this reason that the pre-payment made by the Factor tends to be a lower percentage of the invoice value than in recourse factoring and the Factor’s fees[2] tend to be higher.

1-10    In practice, it is rare for a Factor to offer an unconditional, fully non-recourse facility to a Business. Most Factors will usually conduct an assessment of the creditworthiness of the Business’s Customers in order to decide upon an appropriate credit limit for each such Customer. Invoices raised by the Business to the Customer will, provided that the Business has complied with its various undertakings and warranties and provided that the relevant invoices are within the credit limit, generally be funded by the Factor on a non-recourse basis. However, the Factor will usually have a right of recourse in respect any invoices raised to the Customer and notified to the Factor which exceed the applicable credit limit for that particular Customer.

Disclosed

1-11    Traditional factoring facilities tend to be ‘Disclosed’. This means that the existence of the facility and the assignment of the Business’s invoices to the Factor is made known to the Business’s Customers, usually by way of a notice of assignment (in a form prescribed by the Factor) which the Business will stamp or print on each of its invoices before it sends them to the Customers. In practice, most Factors will also send a ‘Welcome Letter’ (sometimes known as a ‘Take-On Letter’ or an ‘Introductory Letter’) to the Business’s existing Customers at the outset of the facility and to new Customers as and when they start trading with the Business, informing them of the existence of the facility and giving them notice that all invoices raised by the Business have been or will be (if they do not yet exist) assigned to the Factor and that payment of all such invoices should be made to the Factor (rather than the Business) until further notice.

Undisclosed

1-12    Undisclosed Factoring (often referred to as ‘Invoice Discounting’ or ‘Confidential Factoring’) is similar to but different from traditional Disclosed Factoring insofar as the Business’s Customers are not informed of the existence of the facility or the fact that the Factor has taken an assignment of the Business’s invoices. In practice, this means that (initially at least) the assignment by the Business to the Factor can only take effect in equity. This is because a valid legal assignment under section 36 of the Law of Property Act 1925 requires that written notice of assignment is given to the Business’s Customer. Necessarily, the fact that a facility is undisclosed also means that responsibility for collecting the monies due under the invoices is retained by the Business as (for obvious reasons) the Factor is prohibited from having contact with the Customers in relation to the facility. Once in receipt of monies from a Customer, the Business will remit the gross invoice value to the Factor and the Factor will deduct the value of the advance payment, any accrued interest and its agreed fees. It will then remit the balance of the invoice value to the Business.

1-13    Undisclosed Factoring may appeal to some Businesses who wish to take advantage of the benefits of invoice financing but are concerned that their Customers may not be receptive to the interpolation of the Factor into the existing commercial relationships between themselves and their Customers. For example, where the Business’s credit control team generally has a good working relationship with the accounts departments of the Business’s Customers, the Business may not wish to jeopardise the good will accrued between the parties by handing over debt recovery to personnel of the Factor with whom the Customer is unfamiliar. Equally, there may be commercially sensitive reasons why a Business might not wish its Customers to be aware that it is using a factoring facility.

1-14    Given that the Factor has no direct contact with the Business’s Customers under the terms of an undisclosed factoring facility, the risks to the Factor are inherently greater than where the facility is disclosed to the Customer. For one thing, there is sufficiently more scope for the Business to engage in malpractice, either by inducing the Factor to make advance payments on the basis of fictitious invoices raised by the Business in respect of non-existent transactions (sometimes called ‘Fresh-Air Invoicing’) or by directing Customers to make payment to an alternative bank account in respect of which the Factor has no control or visibility. The fact that the Factor is unable to make contact with the Business’s Customer directly necessarily means that the Factor’s opportunities to identify such fraudulent activity are limited. For this reason, undisclosed facilities tend to be offered only to established Businesses with proven credit control infrastructure, high turnover and a healthy credit history.


CHOCC/CHOCS

1-15    CHOCC (‘Customer Handles Own Credit Control’) or CHOCS (‘Customer Handles Own Collections’) is a hybrid form of factoring which combines aspects of traditional Disclosed Factoring with aspects of Undisclosed Factoring/Invoice Discounting. It is sometimes also known as ‘Disclosed Discounting’. Where the Factor and the Business enter into a CHOCC agreement, the fact that the Business is using a factoring facility is (as per the traditional factoring model) disclosed to the Business’s Customer and the Business’s invoices will usually be pre-printed/stamped with a notice of assignment requiring the Customer to pay the Factor directly. However, as per the invoice discounting model, the Business retains control of its own debt collection and credit control. Like other forms of factoring, a CHOCC facility may be recourse or non-recourse.

Spot Factoring

1-16    Spot Factoring (also known as ‘Selective Invoice Financing’) differs from traditional whole turnover/whole ledger factoring insofar as the Business may select only one or several invoices to factor rather than entering into a long-term facility whereby it is obliged to assign all of its present and future invoices to the Factor at the outset of the facility and incur ongoing fees. Generally speaking, the process works in much the same way as traditional whole turnover factoring, with the Factor taking an assignment of the individual invoice/invoices and either assuming responsibility for collecting it/them from the Customers or leaving this for the Business to do. Spot Factoring can be disclosed or undisclosed, recourse or non-recourse.

 

1-17    Spot Factoring may be of benefit to Businesses whose cashflow is generally healthy but who, for example, may have taken on a long-term contract whereby their Customer is entitled to pay on a staged basis or when all aspects of the Business’s obligations have been performed. If, from the Business’s perspective, the contract is a large or onerous one in terms of resources and/or initial financial outlay, this can have a significant impact on cashflow and hence the option of Spot Factoring is likely to be an appealing one to a Business in this position. Additionally, some businesses may see it is an advantage that the majority of Factors offering Spot Factoring facilities do not require additional security from the Business in addition to the assignment of the invoice(s) (e.g. personal guarantees and/or all-assets debentures). However, because a Spot Factoring facility is, by definition, a ‘one-off’ facility with only one or a small number of invoices being financed by the Factor, the Factor’s fees tend to be higher than they would be in the context of a long-term facility where the Factor’s risk is typically lower.

 

Reverse Factoring

1-18    Reverse Factoring is a collaborative process involving the Factor, the Business and the Customer. The key difference between Reverse Factoring and the traditional factoring model lies in the fact that it is the Customer, not the Business, who enters into the facility with the Factor. In practice, Reverse Factoring usually works as follows:

  • The Business and the Customer enter into a contract/trading relationship whereby the Business agrees to provide goods and/or services to the Customer;
  • The Customer enters into an agreement with the Factor pursuant to which the Factor agrees to pay the invoices raised by the Business to the Customer directly to the Business on the Customer’s behalf;
  • The Business provides the relevant goods and/or services to the Customer and raises an invoice;
  • The Customer confirms that the invoice is due and payable and passes it on to the Factor for the Factor to make payment directly to the Business;
  • In return for an agreed fee payable to the Factor by the Business (usually deducted by the Factor from the gross invoice value payable to the Business), the Business has the option of calling on the Factor to pay the invoice to the Business within a matter of days (i.e. considerably earlier than the Business’s standard payment terms demand), thereby assisting the cashflow of the Business;
  • When the invoice matures or often at a later date mutually agreed between the Factor and the Customer, the Customer pays the full value of the invoice to the Factor together with interest.

1-19    Reverse Factoring is still relatively uncommon in the UK as compared with the traditional factoring model whereby the facility is offered by the Factor to the Business rather than the Customer. However, the benefits of Reverse Factoring to all three parties (i.e. Factor, Business and Customer) are easy to recognise. In return for a modest discount on its invoice, the Business is guaranteed payment considerably earlier than its terms would usually permit. In turn, the Customer is able to offer the Business an inexpensive means of accelerated payment, thereby cementing and enhancing its commercial relationship with the Business, with the possibility of negotiating better trading terms than might otherwise have been possible. Furthermore, if the Customer is able to agree extended payment terms with the Factor (i.e. terms more favourable than the Business’s standard payment terms), the Customer has longer to pay the invoice and is therefore assisted in terms of its own cashflow. Insofar as the Factor is concerned, it receives a fee from the Business and interest from the Customer on the sums it advances.

Maturity Factoring

1-20    Maturity Factoring differs from traditional factoring insofar as the Factor does not make an advance payment to the Business on assignment of the Business’s debts. Instead, the Business assigns its invoice to the Factor and either after an agreed period of days from the date of the invoice (‘the Maturity Date’) or when the Factor collects the debt from the Customer (whichever is sooner usually), the Factor pays the Business the full notified value of the invoice subject to deduction of its fees.

1-21    The advantage of Maturity Factoring for the Business is the fact it provides the Business with certainty: knowing when and how much it is going to receive on any given date enables the Business to plan and regulate its cashflow more efficiently. Additionally, where the facility is non-recourse, the risk of bad debt is assumed by the Factor.

Industry-Bespoke Factoring

1-22    Many Factors provide factoring facilities which are bespoke to particular types of Businesses. These tend to be Businesses operating in industries where cashflow is problematic due to a significant time-lag between the delivery of goods/services and the date of payment by their Customers. For example, Employment Businesses which provide temporary workers to their Customers will pay the wages of those workers themselves in the first instance and will then seek reimbursement from their Customers at a later date. Normally the Employment Business will need to pay its workers on a weekly basis whereas, depending on the payment terms agreed with its Customer, it may be anything between 30 and 90 days before the Business receives payment from the Customer. Self-evidently, this time-lag can be problematic in terms of cashflow. For this reason, many Factors offer facilities whereby they will pay the wages of temporary workers directly to those workers on receipt of certified time-sheets (provided by the Business or, in certain circumstances, by the Customer on a self-billing basis) and will then collect payment of the Business’s invoices from the Customer at a later date, deducting the advance payments and their fees before crediting the balance to the Business.

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[1]    See at 2-10 and 2-11

[2]    See Chapter 3