Factoring: Is It Always About the Account Debtor?

We all know that factoring has been around for ages and due to the recent changes in the economy its popularity has increased dramatically. With financial institutions constricting credit to businesses, the increased demand for cash flow has created an opportunity for the asset based lending industry especially for invoice factoring companies. Just type “invoice factoring” or “accounts receivable financing” into your favorite internet search engine and you will find pages of company listings and articles related to this topic.

Factoring Company Competition

Along with this newly found popularity, competition within the industry has increased and everyone wants to make a deal. Common slogans are,

“Same day funding since we base our approval on your client’s credit,” or “Even if your credit is poor, we can still get you funded.”

Conventional wisdom within the factoring industry has always stressed that deals of this nature can be funded since it’s the client’s customer (otherwise known as the account debtor) that will actually be paying the factoring company. For example, a small consulting firm with little or no credit can get funded as long as their customer is creditworthy.

While much of this long standing rule is true, should all the focus of your due diligence be solely on the account debtor?

Providing Factoring Services In Today’s Economy

As I mentioned earlier, the same current economic climate that has created opportunities within the asset based lending industry can also be your worst enemy. Unfortunately, many businesses needing factoring services have taken some tremendous hits over the last few years. We have seen industry declines in apparel, transportation, manufacturing and staffing to name a few.

If your prospect is in a declining industry and sales have slowed, generally, some bad things start to occur. Unless they have sufficient cash reserves (which most don’t otherwise they would not be calling you) vendor payments get pushed back, payroll may be late and taxes go unpaid. Many times your prospect may need factoring just to stay afloat until the inevitable happens and you are left holding the bag.

Dealing with a client who has just declared bankruptcy is the last place where you want to be as a factor. I am not a lawyer and if you ever find yourself in this position, I would suggest that you consult one as soon as possible.

Reducing Factoring Risks

While there are no exact formulas for you to avoid risky clients, there are several steps you can take in your due diligence to mitigate your risk and limit your exposure:

• Run current credit reports on your factoring prospect. There are numerous credit reporting agencies you can utilize that will provide as little or much as your budget can afford.

• Gather the most current quarterly and year-end financial reports available. If the client has audited financial statements, read the auditors notes to the financial statements. Also, look for trends on both the balance sheet and well as the profit and loss.

• Request the last two years of business tax returns for both the federal and state returns including payroll tax filings. If necessary, also request personal returns of the owner and or majority shareholders.

• Check with the state where the business is domiciled to see if they are in “Good Standing.” If a business is not in “Good Standing” or “Suspended” it usually indicates they are delinquent with their annual reporting requirements, have not paid their taxes, or have some other form of dispute with the state.

• If the prospect is required to maintain a license to conduct his or her trade, check with the local licensing board to see the license is current. If the license is suspended, you may not have a valid claim against the debtor or in the event of a dispute.

• Run a UCC-1 search to see if there are any liens against the business. This is extremely important since you as the factor will always want to be in first position on all collateral. In some cases there may be another UCC-1 financing statement already in place. This is not necessarily a negative indicator as the prospect may have an existing loan with a bank or equipment financing with another lender. In some cases the other secured party may subordinate their filing to allow you to be in first position on the prospect’s accounts receivable.

These are just a few basic steps you can take when performing due diligence on your prospect. Every deal is unique and your due diligence may vary according to the type of prospect and the industry in which they participate. Remember, no matter how well your Factoring Agreement between your prospect and you is written, as Benjamin Franklin so correctly stated, “An ounce of prevention is worth a pound of cure.”

About the Author: Don D’Ambrosio is the president of Oxygen Funding, Inc., an invoice factoring company located in Lake Forest, California. For more information, he can be reached at don.dambrosio@oxygenfunding.com or you can visit his company’s website at www.oxygenfunding.com for accounts receivable factoring.