Second in a 3-part series: How Factors Determine Rates
By Advance Business Capital

Quick review. So far we’ve learned: 

• Factoring is a form of financing suitable for any business that issues invoices paid in 30-90 days.
• Unlike banks, factors are buyers and not lenders. Banks lend you money based on collateral. Factors buy your invoices, but not for the full amount.
• Recourse factoring means if your debtor doesn’t pay your invoice, the factor has legal recourse to get its money back from you.
• Non-recourse factoring means if your debtor doesn’t pay, the factor is stuck with the debt. It has no recourse. For obvious reasons, Non-recourse is more expensive than Recourse.
• Factoring is a three-party transaction. The parties are the seller (the carrier), the debtor (the shipper) and the buyer (the factor).
• There are three parts to the factoring transaction: the Advance (the money you get immediately), the Discount (the factor’s profit) and the Reserve (money held back until paid by debtor).
• The factor determines your rate through three variables: (1) the invoice volume you finance, (2) the creditworthiness of your customers and (3) bill aging

Our Story So Far
Back to our examples from Lesson 7. FastFleet is a small thirty-tractor company owned by veteran trucker Herb Gozersky and two investors. It’s been in business eleven years. HotDog Delivery is a two-rig meat hauler run by Mike and Enrique Ortiz. It’s only two years old. Both have been accepted as customers by Crown Factoring, an established and reputable firm.

Crown factors FastFleet’s account, which is $250,000 a month, at a discount of 3%. That means Crown keeps 3% of the total invoice value; in this case, $7,500. Crown factors HotDog’s account, which is substantially smaller, $35,000 for a discount of 6% or $2,100.

Sidebar: As mentioned in Lesson 7, in factoring a “discount” benefits the factor, not the trucker. It’s confusing because as consumers we usually think of discounts as a savings, i.e. reduced-price merchandise. However, in this case the “merchandise” is your invoices; you’re the seller and the factor is the buyer. The smaller the discount, the better for you. Keep that in mind.

Here’s where we left off last month’s lesson. Crown has agreed to factor an advance of $242,500 to FastFleet and $32,900 to HotDog. Since Crown is well known for its fast advances, that means that within 24 hours, both carriers will receive checks for those amounts, right?

Wrong. In fact FastFleet’s check is only for $225,000 and HotDog’s is for just $28,000. So where’s the rest of their money?

The Reserve
The money is in Reserve. All factors hold back a certain amount of the advance as a reserve. The amount varies (we’ll go why into in a moment). The purpose of the reserve is to reimburse the factor for late payers or no payers. FastFleet and HotDog receive their reserves as each of their debtors pays. Assuming all debtors pay, both companies eventually get their entire advance but not immediately.

Is that fair? Crown has already held back money as its discount. Can’t it make good late payments or disputed payments with its own money and then charge its customers?

Sure it could, but would you? Crown makes its money by providing money right away. Likewise, it hopes the invoices it’s bought from FastFleet and HotDog are paid right away. If they aren’t, any money Crown loses from the delay eats into its profit.

Know Before You Sign
The size of the reserve is commonly the most argued area of factoring, and the time to argue is before signing a factoring contract, not after. A reputable factor will make the reserve clear both verbally and in writing, but there are factors who will deliberately keep that part fuzzy until you get your check. If it’s less than you expected, odds are that’s why. So long as no one has lied and so long as the reserve is stated in the contract, you haven’t been cheated, at least not by the letter of the law.

In this case, Crown was upfront with FastFleet and HotDog about exactly how much would be held in reserve. Let’s examine their respective hold-backs though. Crown kept 10% of FastFleet’s advance and 20% of HotDog’s. Why?

Two reasons. First, Crown’s deal with FastFleet was Recourse. That means if someone fails to pay, Crown can litigate FastFleet for full reimbursement of the invoice. However, its deal with HotDog was Non-Recourse. If one of HotDog’s customers fails to pay, Crown has to eat the invoice.

That’s one reason, but even if HotDog had managed to get a Non-recourse deal with Crown (unlikely), Crown still would have held back more in reserves. Why? 

How the Reserve Is Determined
The answer is in the creditworthiness of the companies’ customers. FastFleet is an older, more established company that can afford to pass over unreliable customers. There’s a 99% chance all its invoices will be paid within 90 days at the most. HotDog, like a lot of start-ups, has to take more chances. It takes on customers that are questionable risks because it needs the money. It gambles.

All business is a gamble and it’s up to each entrepreneur to decide which gambles are smart and which are dumb. We’ll assume HotDog’s owners, Mike and Enrique Ortiz, used good judgment. Even so, Crown is under no obligation to underwrite their gamble. In this case, Crown has checked the customers’ credit and determined that while some will pay late, all will probably pay. It’s made the advance but held back a sizeable chunk in reserve to cover any delay.

Factoring vs. Banking (review)
Let’s put our lesson on “pause” for a moment and go back over exactly what factoring is. When a factor decides to make a cash advance, your customers count more than you do. A bank loans money it hopes its customer will repay. A factor buys its customer’s accounts receivable, the money other companies owe it. Credit where credit is due.

Valuing your debtors over your company, may seem a little counter-intuitive, but if you think about it, you’ll see the logic. The factor is investing in your debts, not you. Even if your company goes out of business before the debts are paid, the factor will still collect its money (provided there are no liens or other obligations, but that’s a lesson for another time).

Your Money… Just Not Yet
Naturally, the factor holds back more money on shakier invoices, and on some it may not advance money at all. In any case, a reserve is never permanent. The factor is legally obligated to pay it when the invoice is paid. However, the longer that bill stays unpaid, the more it costs you. Why?

That dang bell again. And just when things were getting interesting! We’ll take up the last point in the third part of our lesson on factoring variables. Stay tuned!

In the meantime, here’s your takeaway: 

• Factors consider three variables in determining rates.
• Those variables are finance volume, customer credit rating and bill aging.
• The greater your invoice volume, the smaller the factor’s discount (or profit).
• Factors hold back anywhere from 5% to 25% of the advance as a “reserve.”
• The size of the reserve is determined by the credit rating of your customers, not by your credit rating.

For many truckers factoring is a good deal, but of course not always. Stick with this course and you’ll learn how to tell good deals from bad, and how to make factoring work for you. See you next class!   

www.advancebcap.com