Factoring, or debtor financing, as it relates to business acquisitions is one of those mysterious parts of the Finance Industry that not much of us know a lot about.....
So here's an overview for you...
First things first - What is debtor financing?
Debtor finance is a generic description of a particular funding process, based on the value of a business' accounts receivable ledger.
Debtor finance is also marketed under the guise of invoice discounting, factoring, cash-flow finance, asset finance, invoice finance and working capital finance.
Basically, debtor financing Is the process by which a business owner assigns/sells their debtor book to a Debtor Finance Company who then pay the business owner within 2 to 3 days of the invoice is being issued. The Debtor Finance Company then collect the invoices on behalf of the business owner.
This means that rather than having to wait between 30 to 90 days for payment of their invoice, a business owner can be paid effectively immediately and sells the risk of the potential bad debts onto the Debtor Finance Company.
This is an excellent way for the business owner to manage their cash flow, particularly if their business model incorporates large amounts of debtors who pay on regular intervals.
So then, how can it help you buy a business?
When people are buying businesses they often spend most of their capital buying the business. The traditional banks will usually be happy provide the funds for purchasing the business assets (Plant & Equipment, Stock, and Goodwill) so long as you have enough equity behind you.
However the working capital component (debtors and work-in-progress) is unlikely to be funded by the banks and we often find that business purchasers have overcommitted themselves and their physical assets to purchase the business assets and have not accounted for working capital requirements.
Debtor financing is an excellent way for the business purchaser to get cash flowing quickly into the business immediately after settlement, of the business to help fund working capital, by way of assigning/selling the debtor book to a Debtor Finance Company who then pay the business owner within 2 to 3 days of the invoice is being issued.
The Debtor Finance Company then collects the invoices on behalf of the business owner. This is an excellent way for the business owner to manage their cash flow, particularly if their business model incorporates large amounts of debtors who pay on regular intervals.How does the process work? Here's an example:
Lets assume that a business owner (or new business purchaser) approaches a D.F.C with a debtor book of approximately $1 million.
Firstly, in order to begin assessing the possibility of debtor financing, the D.F.C will require the business owner to make an upfront financial commitment (approximately 1% of the total value of the debtor book), of which 50% is paid immediately and the remaining 50% is paid upon the successful setup of the facility. If the facility cannot be set up (e.g. due to poor credit history or other issues) the financial commitment is refunded to the business owner less The D.F.C’s costs to investigate setting up a facility.
The D.F.C will then ask for a detailed debtor and creditor ledger from the business owner as well as the financials and any interim financials.
The D.F.C is less concerned with the business profitability and is more concerned with the management of the debtor book. They will look to see how the debtor's are spread. E.g. if there is 100 individual debtors for a $1 million debtor book, they will be viewed more favorably than only three debtors over a $1 million debtor book. Note also that they will consider the quality of the debtors (e.g. publicly listed companies) when assessing the debtor book.
After they have looked at the debtor book and have determined the ageing (or debt turns) of the book (e.g. 30 days, 60 days, 90 days) they will be able to issue an indicative proposal to the business owner.
(It's important to note that if your existing bank already has a charge over your debtors under the terms of your existing loans, they will need to agree to a release of these debtors before you can set up a separate debtor finance agreement with a D.F.C)
The D.F.C will then either setup a confidential facility (whereby the debtors are not aware that The D.F.C have purchased their invoices from the parent company) or a disclosed facility (whereby the debtors are made aware that the business owner has assigned the invoices to a debtor financing company).
The D.F.C open a bank trust account in the name of the subject business and all invoices of the company are paid into this bank account. Charges vary, but typically D.F.C's take 80% of the invoice value (since they are already given this amount to the business owner) plus they also deduct their interest and their service fees, and the remainder of the invoice value is passed back to the business owner which then can be drawn down.
Some of the typical conditions that The D.F.C will usually put in place:
- They will finance between 50% up to 80% of the value of the debtor book;
- The amount of financing offered will depend on the quality of the debtor book. For example if there are two or three major clients they will be unlikely to risk financing at 80% since there is a larger risk of loss due to one debtor falling over;
- They only deal with business to business invoices and do not deal with business to consumer debtor books;
- Their minimum facility size is typically around $200,000, which is traditionally the amount of debtors held by a company turning over a minimum of $2.4 million per annum. Their sweet spot is generally between $1 million up to $4 million of the debtor book financing;
- Most D.F.C's will not deal with the construction industry. Unfair you say? Here's why... builders are notoriously hard to follow up for payment of invoices. They also have the problem of progress payments. The D.F.C want to see clean invoices where products or services are exchanged which can be clearly defined e.g. 100 computers at $10,000, or 60 billable hours at $200 per hour etc. The construction industry has a lot of grey areas in it and as such most D.F.C's generally avoid debtor financing to the construction industry.
- Interest rate on the facility varies, but is usually around 12.5% calculate daily paid monthly on the balance outstanding;
- There is also a service fee per invoice, which varies from 0.3% up to 3% of the invoice value depending on the amount of turnover, the industry, the company etc; for example, assuming a business is turning over $2.4 million and is incurring a service fee of .9% the yearly service fees would be approximately $21,000 per annum in addition to the interest payable. The higher the business turnover, the lower the service fee.
- Benefits to the customer's mean that they are not having to leverage their houses to afford the working capital.
- Often the company will require the business owner to take debtors insurance as a means of protecting the D.F.C against bad or defaulting debts.
- If someone is purchasing a business that they will look at the business purchase contracts as well as the experience that the purchaser has in running that particular type of business before offering a debtor finance facility to the prospective purchaser.
How are bad debts dealt with?
Example: say there is $1 million "out the door" (ie paid out by The D.F.C to the business owner for the assigned debtors), and a company owing $200,000 to the business goes down. This becomes a loss of $200,000 to the D.F.C, and as a means of recovering this the D.F.C will typically hold back monies from the bank trust account until this outstanding amount of $200,000 has been repaid through the ongoing trading of the business.
If a debt exceeds 90 days The D.F.C will often stop funding that particular debtor and it then becomes the responsibility of the business owner to collect that bad debt. The D.F.C is usually not interested or involved with debt collection.
For example if there is $30,000 “out the door” The D.F.C will approach the business owner and tell them that they are reducing their online limit (in the bank trust account) by $30,000 until such time as the trading activities of the business have covered that $30,000 shortfall.
The D.F.C does random calls with the business clients to check that invoices have been issued for genuine transactions, to check on "fresh air" invoices.
So, factoring just me be that missing "factor" in getting your cashflow up and running. The facility is expensive, but if it allows you the peace of mind of not having to chase debtors it may be worth it.
Also it may allow you to buy into a business that may be slightly bigger than what you can currently afford now through traditional financing means.
Thanks for reading.
Blair R Macdonald
0433 149 144