Invoice factoring firms have emerged as important providers of business credit that offer entrepreneurs quick access to capital. Factoring has become a popular method of financing businesses due to the competitive rates it offers and the intuitive clauses that do not rely on conventional repayment means like interest.
Quick disbursement of funds and short processing times make factoring an easy option for small business owners. However, despite the benefits of factoring, factoring contracts entail various clauses written in complex legal language that often confuses business owners. Apart from not reading these terms and conditions in factoring agreements, businesses are prone to make a few common mistakes when selling their invoices to a third party.
To reap the maximum benefits from a factoring agreement, businesses must first understand how these contracts work and the various components involved in the process. Apart from apparent fees, certain firms might also mask other charges.
A clear understanding of these fees and terms helps businesses safeguard their interests when they enter into a contract with a factoring firm. In this article, we discuss factoring agreements in detail, including frequently used terms and fees, and common mistakes to avoid when signing an agreement with an invoice factor.
What Is a Factoring Agreement?
Factoring agreements facilitate invoice factoring; a form of financial funding that allows businesses to sell their unpaid invoices to third-party factoring companies. These contracts include the costs, terms, and conditions involved in the process of invoice purchase by factoring companies. When they are approved for invoice factoring, businesses must ratify all the regulations and conditions specified in the document before receiving funds.
What Does A Factoring Agreement Include?
- The most common details in a contract are the upfront fees and the consequences of not meeting any terms mentioned in the factoring agreement.
- Often, this entails the legal obligations of the business owner in case they’re unable to purchase the invoices back from the factoring firm in events such as non-payment of the invoices by their clients.
Why Are Factoring Agreements Important?
- Factoring agreements allow businesses to borrow money against unpaid invoices. Factoring firms recover the payment for these invoices by collecting it from the client that owes funds in return for services fulfilled by the business. The factoring company makes money through the factoring fees mentioned in the agreement and when clients pay their invoices to the company.
- The factoring company acts as a creditor that supplies funds to you in a short period so that you don’t have to wait for your clients to pay their dues. This option is often a great aid for businesses that are strapped for cash and have immediate financial concerns.
- Factoring agreements are also known as accounts receivable factoring agreements since invoices form the bulk of your business’s accounts receivable. They can cover any expenses like payroll and emergency equipment purchases.
- Moreover, businesses can also address their expansion goals with more freedom when they aren’t concerned about immediate cash availability.
Common Terms Used in a Factoring Agreement
Factoring contracts are known to include a variety of terms that might be highly technical. In the case of long contracts, the document might also contain numerous clauses and charges interspersed with the statutes. Some of the common terms used in a factoring agreement are:
Advance Rate
Among the simpler terms in a contract is the advance rate. This term indicates the amount the factoring company will pay you upfront. The percentage paid hovers around 70% to 90% of the total value of your invoices. The advance rate offered by the factoring firm depends on the total amount of your invoices, the credit ratings of your clients, the nature of your business, and its performance over a set period.
Notice of Assignment
When your business agrees to factor in its invoices, you essentially transfer the right to collect any balances owed to you to the factoring firm. The firm will then inform your clients of the change and send them specific payment instructions and other relevant information. While this might sound concerning to businesses, the process is straightforward. Clients might reach out to your business to confirm the change. In case they’re confused, ensure the client understands that any payments made to you will not satisfy the amount owed to the factoring firm and that all payments must be directed only toward the factoring company.
Factoring Commissions
This term entails the fees your business pays to the factoring firm. Commissions often collectively refer to all the charges incurred by you by agreeing to the factoring process. Be sure to check the contract to verify all the individual fees that fall under this term to avoid hidden fees and expenses.
Customer Limit
The customer limit defines the maximum amount of funding that the factoring company will approve for a single client. Even if your actual credit line is $50,000, if your customer limit is set to $15,000, you will be allowed to use only $15,000 for a single client. The remaining $35,000 will have to be spread over other clients of your firm without breaching the $15,000 limit per client. This term is often included to minimize nonpayment risk.
Reserve Account
Factoring firms will place all the funds paid by your clients in escrow in a reserve account. This allows the firms to keep track of payments, the amounts still due, and any outstanding funds that are owed back to your business.
Representations and Warranties
The factoring firm will demand assurances that your business operates legally and is solvent. You will be required to make statements supporting these claims in the agreement and make any representations to avoid losses for the factoring firm.
Fees in Factoring Agreements
Factoring agreements come with numerous fees. These are stated in the agreement by the factoring firm. However, understanding how these fees work is critical to avoid unexpected expenses when you get into an agreement with a factoring firm.
Origination Fees
Also called the draw fee, this term is an upfront fee charged by the factoring company when you’re approved for funding. The origination fee is calculated as a percentage of the total amount approved. For example, if your business is approved for $100,000 and the firm charges a flat fee of 1% of the total amount, $1,000 will be taken out of the funding value to cover this fee.
Termination Fees
Accounts receivable contracts are often signed for a set period. This might range between a few months to an entire year. In case your business wishes to exit the agreement before the completion of this term, you might be charged a termination fee to end the contract prematurely. This fee, too, is often a percentage of the total amount. Watch out for hefty termination fees in the factoring agreement to avoid paying the firm large sums when terminating the contract.
Monthly Fees
Most factoring companies charge monthly fees. This fee is also called a maintenance fee by a few firms. Often, the rate of this fee ranges between 0.1 to 0.5% of the total approved amount. This fee allows the firm to maintain a reserve when offering you funds.
Credit Protection Fees
Factors charge credit protection fees based on the assessed risk associated with your clients. Credit protection fees protect the factoring firms from potentially unpaid invoices and will be mentioned clearly in the accounts receivable factoring agreement.
Lockbox Fees
Your clients will repay the amounts paid on their invoices through a digital platform called a lockbox. Factoring firms will charge your business a specified fee for your client’s use of the lockbox.
Common Factoring Agreement Mistakes to Avoid
Factoring agreements are often compiled in apparent fees and convoluted terms. This often leads to misreading and inadequate understanding of the factoring contract. This results in several avoidable mistakes that must be understood by businesses before they agree with the factoring firms’ conditions.
Failing to Understand Obligations
The factoring company buys the right to collect invoices owed to you by your clients when you sign the revenue purchase agreement from the firm. While the responsibility of payment now rests with the client, in case of non-payment, recourse factoring terms will require you to repay the amount owed by your client to the factoring firm. In the case of nonrecourse factoring, while you might not be required to repay the full amount to the firm, several charges and clauses will still apply that will add up to a portion of the amount disbursed to your business.
Foregoing a Detailed Analysis of the Contract
All clauses, fees, statutes, and deadlines must be read in detail before signing the factoring agreement. If you’re unsure about any of the clauses and terms, reach out to a professional in the factoring firm or contact an advisor to understand the agreement in its entirety. Failing to do so might result in confusion and misunderstanding.
Not Carrying Out Thorough Research
All businesses must thoroughly research the background of the factoring companies they approach. Without evaluating the operational history and reputation of the firm, businesses can potentially agree to exploitative terms or might even become victims of fraudulent practices. Ensure you only trust reputed companies like FundKite when you choose to sign up for accounts receivable factoring.
Sum Up
While invoice factoring is among the more beneficial options for businesses to raise quick funds, factoring contracts come with a variety of complex terminologies and clauses that are often not clearly understood by the average business owner. Paying attention to the details contained within the factoring agreement and the obligations tied to the factoring process will aid in an informed approach to factoring. Moreover, verifying all of the contents and fees mentioned also goes a long way in safeguarding your firm’s financial interests and helps you make the best of the funds you receive when you agree to transfer your invoices.
