Instead of venture capital or
a loan, try a factor for financing
By Jenny C. McCune • Bankrate.com

It can be tough to line up financing when you own a small business. Banks want a track record and assets, something that a startup doesn't have. Venture capitalists or other private investors want a piece of your firm in exchange for their investment -- something you may not be willing to give.

For small businesses that are cash- and asset-poor but rich in accounts receivable, factoring can be a great financing alternative that doesn't involve taking on debt or giving up equity.

A factor buys your company's accounts receivable and fronts you cash -- anywhere between 50 percent and 80 percent of the value of your invoices. The factor then collects your accounts receivable and gives you the remainder owed, less a fee. Fees can range anywhere from 1 percent to 5 percent and depend on how difficult it is to collect what's owed, the volume of the accounts receivable and the number of invoices.

Cash now, and cash later
For example, say your September invoices total $10,000. Your factor will immediately give you $8,000 -- 80 percent of your total. Once the factor collects the rest of the $10,000 from your customers, he will hand over the remainder minus a service fee of 1.5 percent. In total, you'll receive $9,850 of the $10,000.

"The major advantage of factoring is that it gives working capital to a small business without it giving up equity or taking on debt," explains Mace Edwards, president of Edwards Research Group Inc. and publisher of the Edwards Directory of American Factors, available at the company's Web site.

Another benefit of using a factor is that it will act as your company's bill collector, freeing you to pursue new accounts or other business activities. "Let's face it, most entrepreneurs would do anything rather than pick up the phone and dun customers to pay their bills," says Peter Aransky, national vice president of sales and marketing for Oxford Capital, a finance company and factor headquartered in Chicago.

Solving a cash flow problem
Michael Johnson, co-owner of Sun Nurse LLC, a staff leasing firm in Fort Smith, Ark., that specializes in nurses, decided to try factors to avoid the cash flow problems common to staffing companies. Sun Nurse invests $6,000 or more in placing a nurse. To recoup that investment and still make payroll, the temp agency had to ask its hospital clients to pay in 14 days. It was difficult getting the hospitals to pay so quickly.

"We had one person on the phone all the time to make sure that our receivables were coming in," recalls Johnson. "We'd be waiting for our FedEx delivery on Friday with our client checks, so that we could make payroll on Monday."

Because Sun Nurse was a fast-growing small business with few assets, Johnson couldn't get a big enough bank loan to bridge the gap between when the hospitals paid to when he needed to pay his nurses. He found out about factors through a trade association and decided to give it a try. "It's a pretty good success story," Johnson says. "Factoring has helped us grow quickly."

Of course, like any financing, factoring has its minuses. One downside is that factoring is more costly than traditional asset-based loans. Factoring may seem like a cheap option when viewed in the one-month transaction example cited above. But skimming 1.5 percent (and up to 5 percent) off the top of your monthly revenues adds up when amortized over a year.

The benefits of being picky
A company also has to be careful to sign up with a reputable factor since the factor will be working with the company's accounts.

Johnson negotiated with five factors before choosing Oxford. "There are a lot of games that factors can play, so you have to be careful," he says.

The small business owner also says that using a factor doesn't have to be more expensive than getting a bank loan. In the case of Sun Nurse, Johnson's company builds the fees that Oxford charges into its own pricing structure. "What we have done is passed on the interest to the hospital and built it into our price," Johnson says.

Factor's 'stigma'
While factoring can be a great financing vehicle, many business owners don't share Johnson's enthusiasm for this type of capital. That's because factoring carries a certain stigma. Many people mistakenly believe that a company using a factor is going down the tubes. That's a perception that factors have been battling to change. "Let's face it, I wouldn't do business with a company that was in that much trouble," says Oxford's Aransky.

The stigma surrounding factors is falling away, but slowly. That's one reason why you may want to set up a factoring arrangement on a non-notification basis. That means your customers will not be told that their accounts have been sold and will be none the wiser about you using this form of financing.

Keeping in mind these caveats, factoring is a great form of financing for small business owners who are shut out of more traditional means of raising money or who just don't want to take on debt or sell shares in their companies. Although factoring originated in the textile and apparel manufacturing industries, just about any business in any industry can use a factor. Oxford's client list includes manufacturers, wholesalers, service companies and technology concerns. The only requirements are for companies to have invoices and customers that owe money.

The size of the receivables can also vary. Some factors specialize in working with small businesses; others prefer to work with larger companies. To find a listing of factors, visit the Web site of the Commercial Finance Association, a trade association for asset-based finance service providers, including factors. The CFA Web site posts profiles of factor members and these profiles include details of what type (and size) deal they are interested in.

Short- or long-term deal
How long a company uses factor financing varies. Usually it's for a set period but some companies, particularly those with uneven cash flow or limited staff, actually prefer to have a long-term factoring arrangement. They'd rather spend a little more and forego acting as bill collector. In the case of Sun Nurse, Johnson doesn't see a future without his factor. "We don't plan on stopping using Oxford. It's a clean arrangement," he says.

Factoring is a big business. In fact, the current market is fairly competitive, factor expert Mace Edwards says, which means it can be an ideal time to use a factor. To get the best deal, of course, means you must do your homework. Talk to several factors and negotiate with them to get the best terms.

Finally, once you've sign on with a factor, remember to renegotiate as your company's status changes. Michael Johnson's traveling nurse business is growing exponentially. He's gone back to the negotiation table with his factor three times since they first started working with each other. Each time he's been able to negotiate a drop in fees because Sun Nurse's volume of receivables has gone up. That drop in fees is something that any finance-hungry business can appreciate.

Jenny C. McCune is a freelance writer based in Montana

-- Updated: Oct. 10, 2002