Factoring 101 Checklist for Emerging Brands

June 17, 2021

Every emerging brand suffers from cash flow problems.

On average, small businesses maintain $374 of daily cash outflows and $381 of daily inflows, illustrating an extremely slim margin of error. On top of that, the average small business retains a cash buffer on their balance sheets of only 27 days before they’re insolvent. 

To solve these cash flow issues, emerging brands often turn to factoring: a process of selling their invoices so they can get paid today, while the factor will collect on their behalf. It’s an attractive option on the surface: money in the bank today is better than down the road.

However, a handful of additional issues quickly arise. First, banks often charge up to $15 per check with every collection, layered over the cut that factors take off the invoice, which can scale up to 20%. All in, rates and contract add-ons can add up and become quite costly.

Second, there’s an element of uncertainty when B2B customers fail to pay an invoice. If that invoice isn’t paid, the factor will require that you provide a replacement invoice of similar value via recourse factoring, thus further complicating your existing cash flow problem.

Put simply, factoring can be an incredibly useful tool. However, it’s also a short-term solution, purely outsourcing your cash flow problem instead of dealing with it upfront.

At Merchant Candy, we see this problem arise on a daily basis. After chatting with a handful of our partner brands, we aggregated a checklist to review before you sign on with a factor.

1) Get a pulse on your business health

Before signing the dotted line with a factoring partner, dive into your core operating metrics to get a pulse check on your business health.

We recommend digging into specific data around which customers are paying on time, and which might present issues when factors collect. It’s important to note here that factors are incredibly sensitive to risk, and they’ll often require information directly from your customers in addition to reporting data of your own. If this occurs, it’s critical that you ensure your customers are taken care of and the relationship isn’t damaged when a factor gets involved.

More often than not, brands we work with aren’t entirely aware of what B2B customers, and the correlating invoices, are in good standing. Before you sign with a factor, it’s critical that you’re aware of the health of data behind invoices and B2B payments throughout your business.

2) Clarify rates and contract add-ons

In the process of signing with a factor, ensure that you have total clarity around the rates that a factoring partner is charging, in addition to any add-on fees that might be hidden in the contract.

Invoice factoring typically consists of either flat rates and fees or variable rates and fees. Flat rates offer a fixed percentage payment, while tiered or variable rates will increase the longer an invoice goes unpaid. The actual fee itself can vary widely depending on your industry, the amount of invoices you want to factor, and your business’s financial health and runway. 

Outside of the core rates, add-on fees can quickly pile up. Two of the most common add-ons are application and processing fees, or charges for setting up your account and for covering the cost of credit checks. Additionally, service or monitoring fees cover the cost of maintaining your account. Other add-ons include early termination fees of a contract, bank wire fees, and due diligence fees to cover the cost of checking your creditworthiness.

As mentioned earlier, an additional cost can be introduced if your B2B customers don’t pay their invoices. Most factors operate under a recourse factoring model, in which their client is liable to pay for unpaid invoices. It’s the most common since less risk is involved on the factors behalf.

In the instance where an invoice is unpaid and a factor can’t collect, you’ll have to exchange it for another one of your invoices of equal value. In this case, you’re not only taking a haircut via the factor’s typical 20% cut, but you’ll be declaring a loss on an entirely new invoice. 

3) Investigate alternative credit options

Before signing with a factor, it’s best practice to seek out a range of alternative options.

There are two primary types of credit alternatives that can be used to solve your cash flow issues. The first is a revolving line from a credit fund, based on advances against your inventory and accounts receivable. The second is a more traditional credit line from a bank, which can be used in similar fashion to a large credit card, albeit at a lower interest rate.

Both types of credit alternatives will require the credit partner to dive into your business data, specially reviewing the health of aging balance sheets, receivables, and P&L statements. These documents can typically be compiled by your bookkeeper or an outsourced CFO.

4) Arm yourself with actionable data

When it comes to the negotiation process directly with a factor or an alternative credit provider, it’s critical that you arm yourself with as much data as possible before coming to the table. 

More often than not, emerging brands leverage factoring solutions for unproven B2B customers. Once the customer has proven to pay on time at a consistent cadence, the brand will bring them in-house and deal with invoices directly. Put simply, unproven customers present an unknown risk in the form of additional time and capital spent chasing new customer invoices. 

While factors are quite expensive, they’ll take on that unknown risk for a given percentage of the invoice. When it comes to pushing the unknown risk of a new customer onto a factoring partner, it’s important to arm yourself with as much information and actionable data as possible.

At Merchant Candy, we help brands through this process by enabling insight into payment as they come in on a per customer basis. We recommend that you specifically compile reporting data around reconciliation, historical invoice payments, B2B vendor health based on payment history, and aging balance reports at both the customer and company level. 

The same way you wouldn’t sell your car before appraising it’s worth, you wouldn’t seek out a credit solution without evaluating your business health beforehand. When a factor quotes you a high rate, you’ll gain an advantage during your negotiation based on quantitative data.

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