The terms and conditions of an invoice factoring agreement can seem pretty overwhelming at first. To be sure you’re negotiating the most favorable agreement, you need to understand the industry and legal jargon.
This article covers terms you need to know, and potential fees you should be aware of.
What is a Factoring Agreement?
A factoring agreement is a contract in which a third party purchases a businesses’ accounts receivables, which in most cases are invoices. Invoice factoring allows the business to ensure enough cash flow for manufacturing or production.
Your factoring agreement will either be recourse or non-recourse. It’s important to understand the distinction:
- Recourse factoring: Your business is responsible for any unpaid balances on an invoice. This is the most common type of factoring agreement.
- Non-recourse factoring: Your business will not be liable for the outstanding balance of an invoice. Instead, the factor assumes the risk. Non-recourse factoring will generally result in higher factoring fees.
Factoring Agreement Terms
It’s crucial to read and understand your entire factoring agreement before signing. Here are some important terms that you’ll come across:
This rate is the percentage of the invoice that the factor will pay to your business once the invoice is sold. In most cases, you won’t receive the full amount of the invoice upfront. Rather, the advance rate usually falls between 70% and 95% of the invoice amount.
If your full invoice amount is $2,000, you would receive between $1,400 and $1,900 upfront. The advance rate you receive depends on a number of factors, including the invoice value, your industry, and your creditworthiness.
The factoring fee – also known as the discount rate – is the dollar value that the factoring company takes out of the payment of your invoice. Invoices for larger amounts usually have smaller factoring fees, but there are many other variables that impact the rate, including your sales volume and your customer’s creditworthiness. Generally, rates fall between 0.55% and 3.5%.
You can calculate a factoring fee by applying the factoring rate to the face value of the invoice. For example, a 2% rate on a $100,000 invoice would be purchased for $98,000.
If your business factors a $10,000 invoice every month for one year at a 2% rate, you would collect $120,000 in advanced rates, and the factoring company would collect $2,400 in factoring fees.
Sales of Purchase and Receivables
Remember that in a factoring agreement, you sell accounts receivables to the factoring company. You’ll need to specify which accounts receivables you want to factor in the sales of purchase and receivables section of the contract. You may not want to sell all of your invoices.
Notice of Assignment (NOA)
In a factoring agreement, the factor holds claims to the payment from your customer. When you enter into a factoring agreement, your customer will receive a notice of assignment which alerts them that the right to collect payments has been passed to the factoring company.
The NOA is sent by the factor, and will usually require the customer to sign as an acknowledgment. Very few businesses are exempt from sending an NOA, as this document serves as legal protection for the factor.
Invoice Aging Report
A factor uses an invoice aging report to determine the amount of money that your customers owe on an invoice. Usually, this number falls on an assignment schedule of 30-day increments. For example, most assignment schedules follow 30, 60, and 90 day time periods.
This is the maximum amount of funding that the factor will give you for a single customer. The factor sets a customer limit in order to minimize the risk of non-payment. If the factor gave you a $50,000 credit line with a $10,000 customer limit, you could only use up to $10,000 for a single customer. The other $40,000 would have to be used across four or more other customers.
Customer limit affects concentration, which is a measurement of the risk involved in an account. If you have a single customer that is due to pay the full amount of the invoice, then the account is deemed to be a higher risk.
Your factor will have either a variable-fee or a flat-fee structure. When the fee is variable, the fees will accrue for as long as an invoice is unpaid. For example, a factor might charge your business a 2% fee for the first 30 days, and another 1.5% for every additional 30 days that the invoice is unpaid.
With a flat fee structure, you may be charged a higher rate for the first 30 days, but the rate won’t increase. For instance, you may pay a 4% flat fee for the first 30 days of an unpaid invoice, and the same fee would apply for to next 30 days.
The funds paid to the factor by your customer will go into escrow in a reserve account. This account allows the factor to track paid funds, outstanding funds, and the funds that are due back to you.
Schedule of Accounts
This is a report of all the invoices that you want to be factored. The schedule of accounts given to the factor before you sign the contract, and will allow the factor to determine the appropriate factoring fees.
Representations and Warranties
These are assurances given to the factor that your business is trustworthy. Before the factor takes you on as a client, they want to know that your business is solvent and legal.
The factoring agreement will allow the factor to put a lien on some of your company’s assets until the invoice is fully paid. The lien may be against your accounts receivables, or against your company’s personal property. This could include inventory or intellectual property. In the case of a default, the factor will foreclose on the security interests claimed in the factoring agreement.
If you or your factor decides to end the factoring agreement before the contract’s term is over, the termination provisions spell out any resulting payments or fees. The termination provisions also provide clauses that will allow your business or the factor to exit the contract without paying fees.
Factoring Agreement Fees
While many factors are transparent with their fees, many are not. In some cases, fees that a factor charges will not be specified in your agreement. To ensure that you’re not going to pay more than you bargained for, ask directly about the following fees:
Most factors charge monthly fees, which may also be called maintenance fees. These are flat fees that are charged monthly and may fall between 0.10% and 0.50% of the loan amount. These fees serve as reserves for the factor to maintain the loan.
Origination / Draw Fees
The origination fee – or draw fee – is a fixed fee that the factor will charge to cover the costs of researching your customers. This fee is usually charged per invoice and will come out of the advance. For example, if your advance is 85% of the invoice amount, but the origination fee is 2%, then your true advance is actually 83% of the invoice amount.
When calculating the cash that you will receive from a factor, you have to consider the origination/draw fees. Otherwise, you may risk gaps in your cash flow.
Early Cancellation Fees
Usually, fees will result from the early termination of a contract. These fees can either be a fixed rate, or a percentage of your credit. These fees should be specified in the termination provisions.
Credit Protection Fees
These fees typically apply in non-recourse factoring agreements and exist to protect the factor in some capacity from unpaid invoices. Credit protection fees are based on the determined risk from your customers.
Setup & Renewal Fee
The setup fee may also be called a ‘new account fee’. When you open an account, the factor may charge you for a fixed amount for the process of setting up your account. Similarly, the factor may charge you a fee when you renew your contract, even if the renewal is automatic.
Credit Check Fee
To ensure that the factor is not taking on too much risk, the factor will usually do a credit check on your customers. Sometimes, the cost of the credit check is passed on to you. Because many credit checks can be run over the course of a factoring contract, you should be sure to clarify who pays for the credit checks.
Minimum Volume Fee
This is also known as the minimum commission. The factor wants to be sure they’ll make money. Therefore, the factor will specify a minimum dollar amount that they will collect on a monthly, quarterly, semiannual, or annual basis. You will pay the minimum commission even if you don’t factor any invoices.
It’s very common that your customers will pay an invoice through an online database, which is often called the “lockbox”. In some cases, the factor will charge you a fee for the customers’ use of the online payment portal. This is also known as an invoice upload fee.
The factor will usually pass the cost of a wire transfer on to your business. Most wire transfers range from $15 to $30. However, you’ll only need to pay this when you need an instant transfer, as ACH transfers that take one day or more are usually free.
Final Word on Factoring Agreements
Knowing the true cost of a factoring agreement involves both decoding the legal jargon, and uncovering all of the fees upfront. Once you have the terms and rates straight, use our dollar cost calculator to help you find the lowest rate.
That said, other variables impact which factoring company you should choose to work with. In general, the best factoring companies have the transparency that will allow you to make an educated decision.
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Elisa is a digital marketer and freelance writer specializing in the areas of business, sustainability, and sailboats.