Financing is often an integral part of successful business strategy, especially for small businesses looking to scale their operations. As a matter of fact, 43% of small businesses applied for a loan in 2022, with a sizeable 66% of their applications receiving approval. However, loans, much like other conventional forms of financing (be it equity or debt financing), come with a number of not-insignificant caveats. These include variable interest rates, the forgoing of company equity, debts that impact business credit scores in the long term, and in worse-case scenarios, heavy losses, and company bankruptcies.
In the midst of the many diverse types of company financing, invoice factoring is an overlooked option. This type of financing not only protects companies from the consequences of unpaid loans and high-interest rates but shifts the burden to customers and a third-party factor. To better understand how this form of financing and its variations, recourse, and non-recourse factoring, can cater to your business needs, let us first take a closer look at how it works.
What Is Factoring?
Even the most successful businesses can be crippled by cash flow issues, especially when customers do not pay for provided trades or services on time. It is said that a certain number of customers fail to pay on time. To overcome resulting cash flow issues, companies may take out high-interest bank loans or need to follow up repeatedly with customers. However, few companies consider factoring, a business strategy designed to circumvent the effects of delayed payments without wasting company time and resources.
Factoring involves getting paid upfront for outstanding invoices at less than their face value from a third-party company. The company will then assume responsibility for collecting payment in full later on directly from those who made purchases; saving the company time and effort otherwise wasted on chasing customers for payment. This is described as invoice factoring for businesses.
Companies factor in their accounts receivable for a variety of reasons. Some businesses seek cash to meet financial obligations, particularly when faced with an unexpected increase in sales or when accounts payable become due sooner than the terms of payment under accounts receivable.
Invoice factoring offers a variety of options, such as recourse, non-recourse, and modified recourse factoring, where factors and/or the owners assume certain risks associated with invoice collection, and are responsible for any liabilities undertaken in legal contracts signed between the parties involved. In this article, we explore the different types of factoring available today and how you can tailor them to your business.
What Is Non-Recourse Factoring?
Non-recourse factoring is a type of invoice purchase agreement where a factor, i.e., the factoring company, assumes the credit risk and liability of non-payment on a factored invoice. Advance rates are lower and factor fees may be higher than those under recourse factoring, and the business must have an extensive history of prompt, on-time payments and meet the factor’s credit requirements.
Non-recourse factoring is the best choice if the business is risk-averse, but not all factoring companies purchase accounts receivable on a non-recourse basis.
For example, in the construction industry, companies often have long payment terms and slow cash flow cycles, and in the healthcare industry, medical practices often face long payment cycles from insurance companies and government programs. Non-recourse factoring can provide immediate cash flow by selling unpaid invoices to a factoring company, which assumes the credit risk of the invoices.
What Is Recourse Factoring?
Factoring with recourse is the most common type of invoice factoring of receivables, where the borrower is held responsible for the debt if their customers fail to pay. The factoring company collects repayment on the borrower’s behalf, but if they cannot do so, they will seek reimbursement from the business, thus factoring accounts receivable with recourse.
In this case, the borrower must buy back the invoice from the factoring company and attempt to collect the debt from the customers themselves. With recourse factoring, the business owner is liable to possible risk in the event of non-payment by the customer.
Industries that use recourse factoring include manufacturing and retail, where companies frequently have a high volume of invoices and need quick cash flow. If the customer does not pay, the manufacturing company is obligated to repay the factoring company.
Similarly, companies in the retail industry frequently have a large number of customers with varying payment terms. By selling unpaid invoices to a factoring company, recourse factoring can provide immediate cash flow. If the customer does not pay, the factoring company will take payment for the accounts receivable from the business as a recourse payment.
Modified Non-recourse Factoring
Modified non-recourse factoring is similar to non-recourse factoring. Any non-recourse solution can improve the business’ credit sheet by eliminating obligations and substituting them with capital. However, modified non-recourse factoring includes clauses that:
- hold the client responsible for any representations or warranties about the debt that the factor later finds to be inaccurate,
- include credit insurance on the debt,
- and involve higher costs than recourse options.
Recourse vs. Non-recourse Factoring
The difference between recourse vs non-recourse factoring lies in the stakeholder’s liability for the pending payment. With recourse factoring, the business is responsible, while with non-recourse factoring, the factoring company is responsible. It is critical to understand the distinction between the two before deciding how to fund your company’s working capital requirements.
| RECOURSE FACTORING | NON-RECOURSE FACTORING |
|---|---|
| Wide range of advance rates | The low range of advance rates |
| Lower fees | Higher fees |
| Get funds faster | Delay with acquiring funds due to extra documentation |
| It is easy to qualify for factoring. | Difficult to qualify for factoring |
| More common and more flexible | Less common |
| Business is liable for failed payments | The factor takes the riskStrict credit requirements |
| Multi-year contracts | Short-term contract |
| Personal guarantee required | No personal guarantee |
Pros & Cons of Recourse and Non-recourse Factoring
After understanding their differences, it is necessary to note that both types of factoring come with advantages and disadvantages. Let us take a look at the pros and cons of the two types of factoring:
| PROS AND CONS | RECOURSE FACTORING | NON RECOURSE FACTORING |
|---|---|---|
| PROS | ||
| Basic credit verification needed | * | |
| Increased rate of advance | * | |
| Payment flexibility | * | |
| Payments duly collected | * | |
| Factor fees are low | * | |
| Accepts liability in case of non-payment | * | |
| CONS | ||
| Extensive credit verification needed | * | |
| The client retains credit risk | * | |
| Increased fee rates | * | |
| Lower advances | * | |
| The factor does not assume the risk of non-payment | * | |
When to Use Non-recourse Factoring
Both recourse and non-recourse factoring plans provide similar services, so it is important to understand each program’s benefits and shortcomings before choosing the best strategy for your business.
Non-recourse plans have a slight advantage due to their protection against unexpected customer insolvencies.
As a result, non-recourse factoring is a good option for larger businesses with a broad customer base who want to offload their receivables near the quarter or year-end. In exchange for being free of any obligations to the factoring company, if their customers become insolvent, the business may need to be willing to pay extra to the factoring company for this privilege. If the agreed-upon rates are amenable to the business, this can be considered a good option.
Non-recourse factoring is also an option for businesses with risky customers who don’t have the strongest records of on-time payments and fair credit histories. It can protect the business from the liability associated with non-payment from those customers, but it may not be able to qualify if the customers are too unreliable. If the business has the credentials to qualify, it is still a possible option, but it will likely receive higher factor fees and lower advance rates in exchange for that sense of security.
What Is Not Covered by Non-recourse Factoring?
A standard non-recourse factoring contract does not cater to the following:
- Invoices disputed
- Invoices for which the client has violated the factor’s agreement.
- Invoices that are canceled out by other amounts owed to the company.
- Invoices that are sent by the client directly to the customer, as opposed to the factoring company.
To learn if the reasons that money has been lost by the factoring client (the business) are covered under the factoring contract, it is important to review the proposed factoring contract early on in the sales process. If the reasons that money has been lost by the business are not covered under the factoring contract, the factor may still charge back invoices to the client in those circumstances.
Some factoring companies also have various safeguards, such as covering the debt only if the broker or carrier declares bankruptcy or ceases operations. Also, situations such as invoice disputes, breach of contract, and situations in which the business contributes to the credit problem are rarely covered. It is important to read the fine print before signing the factoring agreement.
Which Businesses Should Use Factoring?
Unlike recourse factoring, non-recourse factoring is mostly recommended to manage the finances of businesses that are at high risk of non-payment. This can vary across various industries such as transportation, manufacturing, labor providers, construction, etc. Although factoring is tailored to suit the individual business, there are specific types of businesses for which non-recourse factoring is recommended:
- Startups with limited credit histories or collateral
- Small businesses with limited cash flow or working capital.
- Businesses that sell to customers with poor credit histories or payment track records.
- Companies in industries with longer payment terms or extended collection cycles, such as construction or manufacturing.
- Businesses that want to reduce the administrative burden of managing accounts receivable and collections.
Summary
Factoring is a strategy used to obtain upfront payment from a third-party company for unpaid invoices at a lower rate than their face value. Recourse factoring is the most common type of invoice factoring, where the borrower is held responsible for the debt if their customers fail to pay. Non-recourse factoring is an option for businesses with risky customers who don’t have the strongest records of on-time payments and fair credit histories but comes with higher factor fees and lower advance rates. Some factoring companies have safeguards, such as covering the debt only if either of the companies declares bankruptcy or ceases operations. Choosing the best factoring type for your business depends on its credit score, business type, the nature of the industry, and the number of years since its inception.
