The Mechanics of a Factoring Transaction For businesses that have not used factoring in the past, the concept of entering into a financial transaction that is mechanically unknown to the principals can be daunting. However, factoring is quite simple and intuitive. Factoring is the sale of invoices (accounts receivable) for immediate cash between two willing parties. Factoring differs from a traditional bank credit facility due to the sale aspect – the obligation to collect the amount due on the receivable or invoice is the duty of the factor, not the business that generated the receivable. A traditional factoring transaction has the following components: 1) Company A sells and delivers widgets to Buyer ( also known as an “account debtor”) and presents it with an invoice 2) Buyer agrees to pay the invoice 60 days after widget delivery 3) Company A must pay the widget manufacturer in 10 days 4) Factor buys the invoice and Buyer’s promise to pay from Company A at a slight discount plus a reserve. Company A uses proceeds to pay manufacturer or for general corporate purposes 5) In 60 days, the buyer pays the factor all amounts due under the invoice and the factor remits to Company A the reserve less any outstanding fees and expenses Most factoring transactions are constructed as revolving facilities. As such, the factor will allow the client (Customer A in the diagram) to sell as many invoices to the factor as long as the aggregate amount of unpaid invoices purchased by the factor does not exceed an agreed-upon level (the maximum facility amount). Some factoring programs are established so that the client will only sell one or two (usually large) invoices in one-off transactions, but that is the exception, not the rule. This type of factoring is known as “spot factoring.” 301 Route 17 North, Suite 800 Rutherford, NJ 07070 Phone 201 842 7725 Fax 201 842 7726 343 Third Street, Suite 103-B Laguna Beach, CA 92651 Phone 949 715 1039 Fax 866 931 9952 There are two stages of cash transfer from the factor to the client. An explanation of each is provided below: 1) Stage One: Presentation of an Invoice – Upon sale of goods and services to the buyer or account debtor, clients will submit invoices to a factor for funding. The factor will review the invoice to ensure that the “Remit To:” information clearly identifies the factor’s “lockbox” as the location to send the payment (a lockbox is a secure location, usually a bank, where payments are received, processed and posted). The payee must also be listed as the factor. All invoice payments must be made to the factor’s lockbox because the factor has purchased that receivable and is responsible for collecting and receiving it. This also greatly reduces the need for the client to maintain a collections staff. The initial payment to the client during this stage ranges from 70% - 90% of the invoice amount. The remaining balance, called the reserve, is returned during stage two. 2) Stage Two: Receipt of the invoice payment from account debtor to the factor – Once the account debtor remits the invoice payment to the designated lockbox, the factor will send the reserve amount (the 10% - 30% remaining as illustrated in the example above) back to the client. The reserve amount will be reduced to cover the fees associated with use of the factoring facility; timing is solely determined by the account debtor’s payment. Because factoring is a sale transaction and not a loan, the client does not owe the factor any principal or interest. The cost to use the facility is deducted from the final reserve payment.