Factoring is a financing method that is usually much more expensive than conventional bank financing. Yet it is an important option for SME’s who may not have access to conventional bank financing, usually because of lack of appropriate credit history.

This article will provide a definition of factoring and discuss the circumstances in which factoring might be appropriate, before concluding with some pointers on types of structures for factoring agreements.

What is factoring?

Factoring is a financial transaction whereby a business sells its accounts receivable accounts (money owed to the firm by clients) to a third party, called a factor, at a discount in exchange for immediate money with which to finance continued business. It differs from a bank loan in three key ways. First, the emphasis is on the value of the receivables, not the firm’s credit worthiness. Secondly, factoring is not a loan - it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties, whereas factoring involves three – the firm, the client and the third party or factor.

When is a good time to use factoring?

In most circumstances, where a bank can finance its receivables via a conventional bank loan, this is preferable, as a significantly less expensive form of financing. A revolving line of credit backed by receivables that is offered by a bank may have an interest cost that is a fraction of the discount applied by a factor. However, where a business is a start-up, with insufficient credit history, or if a firm has developed a poor credit history, it may need to resort to factoring. This may be possible where its clients (the parties issuing the invoices) have a strong credit history, hence the factor can look to the strong credit history of the clients to provide assurance of payment.

Given the generally higher cost of factoring, only businesses that are projected to be highly profitable and cash flow positive should consider factoring. In other words, if the business can generate a return on capital that is higher than the cost of capital, adjusted for risk, factoring may make sense. If an illiquid business resorts to factoring out of desperation in order to provide some short-term liquidity, without the ability to generate a higher return than its cost of capital, it will only dig itself into a deeper hole.

Given the general reluctance of banks to lend to SME’s in today’s environment unless there is relative strong security (e.g. real estate or a personal guarantee), factoring may also be a way for a business to be self-standing in its financing, without resorting to collateral or guarantees.

What to look for in structuring factoring agreements?

There are numerous types of factoring agreements. Some of them are what I would call “classical” factoring agreements, where the factor literally buys the receivable at a discount, which means it has no remedy against the business if there is a default on the receivable. Others may be called factoring agreements in name, but in many ways resemble loans. For example, one variation involves the factor advancing approximately 80 percent of the invoice amount at the outset. The balance of approximately 20 percent is kept in a kind of notional reserve pool, paid out when the receivable is paid to the factor, if there is a default on the receivable, or more than 90 days goes by without payment, the factor may deduct it from the reserve pool.

But the devil of any factoring agreement is in the details. What events constitute a default? What are the consequences of default? What are notice and cure provisions? Is there any minimum amount per month or quarter that must be factored? And most factors will insist on the receivables flowing directly from the client to them.

As a result factoring is definitely not appropriate for every SME, but in certain particular circumstances, where bank financing is not available, or the owner wishes to avoid guarantees or collateral, and the business generates a return that is higher than the cost of capital, factoring is a viable option worthy of some consideration.

It has been a week of hell in financial markets: S&P downgrades US Treasuries, the Dow plunges below 11,000, stock markets all over the world give up trillions of dollars in value. Riots from the UK to Israel. Safe haven investments such as the Swiss franc and gold reach new highs … Where does this leave the average SME (small or medium-sized enterprise) owner? Consider the following five likely outcomes:

1. Revenue stagnation

What has happened in the past week or two is a sea change in the outlook of financial markets. Whereas two weeks ago financial markets seemed to reflect a cautious optimism that a slow global recovery was under way, markets now reflect a scenario of stagnation, in some countries potentially even a double dip recession. So unless you are in one of those fortunate niches that can’t keep up with demand (for example the entire supply chain of Boeing and Airbus is struggling to keep up with a five year backlog on aircraft orders), your revenue outlook may be considerably less optimistic today than two weeks ago.

2. Ongoing volatility

The best prognosis is that markets will continue to lurch from crisis to crisis. There is no credible solution yet in place for the debt problems of the peripheral European economies. The US will lurch between between slamming on the fiscal brakes (the Tea Party’s desire to reduce the size of government spending) and stimulus, in the form of new forms of quantitative easing and job creation programs – each with its own set of problems. Even China teeters on the edge of a contraction, according to some market watchers.

3. Liquidity will be at a premium

Companies will likely stretch their payables even more, cash will be at even more of a premium. Liquidity may become an even more important source of competitive advantage.

4. It may become more difficult to raise financing

Banks may become even more cautious in lending. Private equity will likely become even more cautious in cherry picking quality deals at more conservative valuations. M&A markets may become even more of a buyers’ market. Yet for business owners, it may be important to seek financing to ensure liquidity, even survival, in the potentially lean months ahead.

5. A shift in asset classes?

Many market observers are saying that now is a good time to buy equities, taking advantage of current low valuations. They may be right. But one must also ask the question: Is there a long-term shift among asset classes here? Just as the decade leading up to 2008 was a decade of soaring equity values and above-historical returns, the subsequent decade may go down in financial history as a decade of equity price stagnation, horizontal movement and volatility. Since 2008, an investment in commodities (e.g. gold) would have performed better than most equity portfolios.

The two major financial markets in the world – the US and Europe – each have their own sources of instability moving forward:

• The US highlighted its own political disfunctionality in not being able to resolve an artificial, self-inflicted, problem – namely raising the debt limit – until the eleventh hour. This does not bode well for creating the political consensus to solve the real (and infinitely more difficult!) issue, diminishing the vast imbalance between projected revenues and expenditures.

• Europe continues to suffer from the lack of centralized institutions, (giving it, for example, the ability to levy taxes, drive expenditures and issue bonds at the European level), an advantage that the United States enjoys vis-à-vis Europe. While the consensus for further integration does not (at least yet) exist, the lack of such centralized institutions makes it far more difficult for Europe to respond credibly to financial crises.

Working through both of the last two issues is optimistically a decade-long agenda for both Europe and the US. In the meantime, markets may lurch from crisis to crisis, which will either help create the incentive for political consensus to resolve the above issues, failing both the US and Europe will see huge difficulties ahead. Scenarios include the European Union losing members, or the US dollar losing its status as reserve currency.

Given the developments of the past week in financial markets, the worst approach by business owners would be to take the ostrich approach: to stick one’s head in the sand and pretend that nothing has changed. These are momentous changes. How does this change your business?

Parties to a transaction do not always realize the extent to which time is of the essence in closing a transaction. I will give three cases which illustrate why time is so much of the essence, then draw certain conclusions:

Case #1: In 2001, I was working on a major telecom transaction, where numerous offers arrived on the company we were selling. After a process that had taken over half a year; the best offer was still $20 million short of our client’s expectations. After weeks of very hard bargaining, the gap was reduced to $5 million. The momentum was promising. And then something extraordinary happened: September 11. As result of the Twin Towers disaster, financial markets were greatly perturbed. The gap was back to $20 million. And the whole transaction was called off.

Case #2: I also heard of a case where the last of several signatories to a deal was to sign the papers on a Friday. He was not feeling well and asked to defer until Monday. The only problem was that the signatory passed away on the weekend. No one else in the company was willing or able to take responsibility and sign the deal. Once again, the deal fell through.

Case #3: The due diligence of a particular deal dragged on months longer than what was normal. Once the due diligence issues were resolved, the purchaser of the company noted that there had been a major fluctuation in currency which greatly diminished the value of the company in question. While a compromise on valuation was eventually reached, and price renegotiated (it was touch and go: the deal could just as easily have fallen through), the delay and renegotiation still cost the seller millions of dollars.

As the above cases indicate, there are all kinds of uncertainties that may affect a deal. The above cases all point to the same conclusion: when there is an active negotiation on a transaction, negotiations need to take place with maximum speed, and none of the parties should rest until closure of the transaction. This is one of the reasons why M&A transactions tend to be ‘round-the-clock marathons. (Or perhaps a party has a vested interest in drawing out the time line, to take advantage of such uncertainties?)

The above cases also illustrate why sellers of companies need to be fully prepared before going to market, whether to raise additional capital, find a strategic or financial partner, sell a minority or majority interest.

Where they are not fully prepared, the companies are unnecessarily opening themselves to a lengthier-than-necessary sale process. Better to have a thorough information memorandum, data room, financial model and management presentation fully prepared before going to market, thus minimizing the amount of time that a company is actually on the market.

In today’s financial market, and for the foreseeable future, there is likely to be a huge amount of volatility and uncertainty.

Whether it’s the potential of the US Congress not lifting the debt ceiling and the US defaulting on payments, or the default of Greece, or any number of risks which affect today’s financial markets, an event can happen tomorrow or next week which may close your financing window, the same way 9/11 closed the financing window in the first case.

Today may not be the best financing market – many people are putting off financing or transactions until markets improve. But if you are counting on today’s financial markets to raise cash, don’t take it for granted that markets will improve. Until the agreements are signed and money changes hands, virtually any deal can fall through.

In most cases company owners will be best-served by taking a company to market only once preparations are fully complete, and then close the transaction as quickly as possible.

Only 8 percent of businesses offered for sale are actually sold in the UK, and that statistic is likely similar for other countries. There are probably three main reasons: 1) some businesses don’t have value; 2) in other situations, there is a wide valuation gap between buyer and seller; 3) often there are risks in a business that a buyer is unwilling to assume.

A privately held business is perhaps the most illiquid form of investment. It may take many months, even years, to sell a company.

So how can one best maximize the chances of a successful sale? I would suggest paying attention to the following five areas:

1. Know thyself. Does the business owner really want to sell? Particularly for those business owners facing retirement, there is often deep psychological resistance to selling a business. Giving up travel, an expense account and a life with a mission can be difficult, especially if moving to retirement. Some owners may get to the final phase of a negotiation, get cold feet, and suddenly withdraw, without fully understanding the reasons themselves. Bottom line: business owners need to understand their own motivations, and when exiting to retire, need to plan and prepare themselves for the subsequent phase in their lives.

2. Understand your objectives. Is the objective to maximize transaction revenues? Or reaching a predefined minimum price? Speed of a transaction? Looking after future family generations? Often objectives can be contradictory: maximizing speed, for example, tends to reduce price. It helps to have a written definition of objectives. Few things focus the mind like putting objectives in writing. Then set a plan for achieving your objectives.

3. Build scale and profitability. Most people intuitively understand that the more profitable a business, the easier it is to sell. But it is perhaps counter-intuitive to learn that selling a $10-$20 million business is actually easier to sell than a $1-$2 million business. Larger businesses typically have more critical mass, better systems, better staffing and governance. Hence there are typically more potential buyers for larger businesses. A small business often does not “move the needle” for many buyers.

4. Build the business from the perspective of an investor. Every now and then, a business owner should be like a fly on the wall, and assess his or her own business objectively, from the perspective of an investor. (Or ask an objective outsider to do it.) Is this a business that would be desirable for investors? Which investors? How much would the business be worth?

I once advised a business owner that every dollar generated in his fledgling online business generated eight times as much value as in his conventional business. He immediately postponed any plans for sale, and decided to work for a few years on building up his online business.

Sometimes I find businesses that are involved in too many incompatible business lines, hence not of interest to any buyer. (For example, one of my clients had businesses in construction, aviation-related manufacturing, and non-core assets.) Such companies generally require restructuring prior to sale.

Both of the above situations illustrate how a business should be built from the perspective of investors. There is often a paradigm shift involved when business owners who build a business in their own image realizes the need to build a business that will survive, most often via a sale, and hence be of interest to investors. Neglecting this rule can result in a business that is illiquid or unsaleable.

5. Begin exit planning as early as possible. I am often asked when the best time to begin planning an exit is. My answer: when you consider buying or founding a business. It’s never too early. Too many business owners spend decades building a business without planning for exit. It’s then often too late to do estate planning or tax planning, let alone applying all of the principles mentioned in this article. A fundamental reason for the success of the private equity industry is that they take a very hard look at exit before investing in a business. You need also to take time to build your team, both internal staff and external advisors (lawyer, accountant, financial advisor) that will assist you with the transaction.

Think of building and selling a business not as two separate acts, but as part of the same continuum – in the same way that mountain climbers, when planning an expedition, plan not just for the ascent, but also for the descent. A business should be built with exit, or at least succession, in mind.