My friend Mike Selfridge at Silicon Valley Bank has this great post in CFO Magazine:

The CFOs I know don’t typically think of themselves as bankers, but a walk in wingtips would serve them well. Paramount to a bank’s success is the chief credit officer, responsible for the institution’s credit portfolio, lending practices, and overall risk management. Successful policies established by the chief credit officer lead to a strong financial foundation, which in turn spurs future growth.

In many regards, the CFO position is akin to that of the chief credit officer. Both extend credit to clients, implement strong policies and procedures, and ensure that the extension of credit supports the firm’s overall strategy for growth — without compromising its financial condition. CFOs can thus borrow from the chief credit officer’s playbook when establishing an effective credit policy and process, or when fortifying an existing one.

The objective of a good credit policy is to establish approval authorities, define the guidelines, outline responsibilities, and specify the lending practices that will be employed when extending credit to customers. Policy objectives cannot be accomplished, however, without an emphasis on credit quality, which is enhanced by a thorough knowledge of clients and their businesses, as well as a thoughtful evaluation of risk, supported by proper documentation.

By using industry benchmarks, a credit policy can provide stated goals for such credit metrics as days sales outstanding, bad debt expense ratios, and the allowance for doubtful accounts. For banks, net charge-offs are the equivalent of bad debt expense, and a net charge-off ratio of less than 0.75% of average loans is considered acceptable by most commercial lending institutions. Less than 0.50% would be strong. For corporations, depending upon the industry and its typical gross margins, a bad debt expense ratio of less than 0.25% would be acceptable.

Read his entire post here.

There is a time limit for factoring companies that require a financed invoice to be paid within ninety days. In other words receivable financing is only for businesses that issue 30 day net term invoices and have a history of getting paid in a timely fashion. If the cash flow model of your business is not getting payment for work completed within a relatively short time (vs. quarterly or annually) then factoring invoices might not be a solution for you.

The reason is, the arrangement a factor has with its funding source usually is a leveraged institutional bank line. The bank lends money to the factor who then turns around and makes advances to their clients. When calculating the daily available credit to the factor, any outstanding invoice over ninety days is considered a non-performing asset and is deducted from the available credit line.

In some cases, a normal 30 day invoice will age over 90 days. In these situations a recently finished job with a new invoice is swapped for the overdue invoice, thus retiring the old one. But this should happen only on rare occasions or the factoring company will pay closer attention to your business model.

To a factoring company, an invoice is not an invoice until the work has been completed. The factor will not make an advance on a job that is not finished. This is considered “pre-billing.” It is true even if the arrangement is completely within agreeable terms between the factoring client and their customer, and has been going on over an extended period. For accounts receivable to be considered “live,” the factoring company must be able to independently collect from the account debtor. If the customer doesn’t consider the job done, the factor will not be able to collect on the invoice. Receivable factoring requires contact with the customer to verify that the job is accepted and the invoice is in the accounts payable system with the remittance to the factoring company’s address. Until the customer does this verification, the funding will be held up.

The situation usually comes up in two ways; the client is so new they badly need capital to get the job done. The client in this case is terribly under-capitalized and needs help from someone other than a factoring company. The second is when the business model was set up originally to accept pre-billing. Sometimes this might be a requirement of the customer, or lack of debt financing forethought by the borrower when setting up the model. Tweaking the business model a little can very easily remedy the problem if the factoring client is motivated.

Many small businesses are being swept up in the banking community’s efforts to tighten up their credit facilities. Banks all over the country have begun to inform their borrowers that they are out of compliance with their notes. Obviously this comes at a terrible time and is compounding small companies’ attempts to stay in business. As revenues decline on a business balance sheet, the collateral used to borrow capital has decreased forcing the bank out of their regulatory role of making sure the loan remains liquid. The bank, when it first considers making a loan finds that there is a.) enough liquid collateral available to satisfy the note and b.) the profit margin is strong enough to make monthly payments.

As the economy suffers, the collateral and balance sheet weaken. It seems the banks decided to tighten up their credit standards in the beginning of 2012. They are asking small businesses with a line of credit to pay off the line completely before being able to borrow again. This allows the bank to know whether the business has the wherewithal to pay off the loan. It shows the bank that the small business has other assets and good judgment. This process will undoubtedly weed out a lot of companies that are barely hanging on and are grossly undercapitalized.

Small companies that secure a line of credit with a bank should be using a greater amount of discipline when accessing this form of capital. You should never take money out of a line of credit without having a plan to replace it. This discipline of taking money out and putting it back in keeps you in compliance and actually increases your credit rating. The lender sees the track record of borrowing and payments and deems the credit risk acceptable. Unfortunately, many companies see the line of credit as way to defer the inevitable. A bill needs to get paid. Using a line of credit just makes the date it gets paid sometime later in the future.
With invoice factoring all of this becomes moot. Factoring does not have a limit of how much you can borrow, you don’t have to worry about paying off the note because each invoice acts as its own loan. Once the invoice is paid the note is satisfied and you move on to the next one. So the factoring company provides the discipline and the small business can stay out of trouble.

Whenever a business, let’s call it Acme, provides a service or sells a product to another company and offers that customer credit terms, they are essentially loaning funds to the customer. Now Acme becomes a bank helping grow their customer’s balance sheet by offering interest fee credit. At this point Acme has significant capital tied up as accounts receivable and has to wait for their customer to pay their invoice.

A factoring company provides access to those tied up funds, allowing Acme to make timely payroll or use the working capital to pay off bills. The first thing the factoring company will do is determine the creditworthiness of Acme’s customers. The decision to fund an invoice is determined by the credit of the account debtor – the entity paying the invoice. Once this has been verified, the factoring transaction is very simple to follow. Generally there are 3 parts; the advance, the reserve, the fee.

The advance is the percentage of the invoice that gets funded when submitted, this can be around 80%. The remaining 20% is held in reserve until the customer pays the bill directly to the factoring company.  Once this occurs, the factor deducts the factoring fee and the remainder of the reserve goes back to the client, in this case Acme.

The major benefits to this form of finance are; the customer’s credit determines the funding, as each invoice gets paid the “loan” is retired and there no longer is a lingering liability. And for the most part, there is no ceiling when it comes to growth. Acme can grow and grow without having to reapply for a larger line. Should you have any questions regarding invoice factoring, please call us today so we may help you.

One of the best kept secrets of business financing is invoice factoring. With all the commercial financing available the concept of factoring accounts receivables for operational cash flow is still not widely considered. The mechanics of the transaction are very easy to describe, simple to set up, flexible to use, and becomes critical to the many companies who utilize its benefits.

While there are so many types of financing available; bank term loans, revolving lines of credit, loans with warrants, asset based loans, direct public offerings, mezzanine financing, private placements, all sorts of equity participation, a company looking for outside capital has to be aware of, and have some basic understanding of the pros and cons of all forms of financing before choosing one method.

Be advised, factoring is a tool that is perfect only for certain situations. Capital intensive requirements like labor costs and product purchases are ideal for growing companies seeking to use the factoring model. Businesses with healthy profit margins and strong creditworthy customers will work well with a factoring company.

For the past year I have been offering invoice factoring tips and insights into the process of commercial finance for small business owners. Even as the economy remained in a stall at the beginning of 2011, many struggling businesses continued providing critical care to this struggling economy.

Without casting blame, the beginning of the year saw a retrenching by many banks who might have felt their lending practices lacked proper attention and accountability. In the previous year the banks which are regulated, were basically trying to hold onto a steady balance sheet in order to avoid being swallowed up by a healthier institution. This meant a bank was less likely to do loans that had any risk at all figuring they would be better off getting a gift from the FDIC of an entire portfolio from another bank in decline.

This brought terrible repercussions to borrowers as their “new bank” could change the rules and ultimately toss you out if your loan did not conform to sometimes seemingly arbitrary decision making. This caused companies to seek ongoing financing from lower tier resources, like a factoring company and often created high stress situations which is the worst situation to be in when courting a new lender.

Much of this chaotic business settled down by the end of the summer and banks soon realized they had to get back to their mandate and start lending money – for if they are not lending they are not going to be profitable. So by now, commercial lenders are once again hungry for deals and eager to help tailor the needs of their client with the requirements of the institution. We in the factoring industry fill the void left by a lack of commercial lending by the banks.

Unfortunately the business community was going through changes in parallel to what was happening to the lenders. Companies were for too long relying on easy to obtain credit and had overextended their balance sheet while experiencing a downturn in the economy. The results were less receipts and over extended credit with no one around to bail them out. Unfair yes, but still a reality that some astute business owners dealt with better than others.

Going into the New Year everyone has to get back to basics. Increase sales and cut costs by working more efficiently is the mantra in order to find success. Additionally companies need to adopt the discipline to work within the confines of their profit loss statements. Become smarter getting the word out about your capabilities; invest in your own personal growth as well as the growth of the company. In any game, the person who makes the most mistakes looses, and the ones who stay immediately focused on the task at hand win.  Good luck to you in 2012.

Along Red Creek Trail, Monongahela National Forest, WV 2011

All of us here at Creative Capital Associates, Inc. would like to extend our hearty best wishes and offer a big Thank You to all the people and businesses we have come across over the past year. While being thankful we wish everyone continued success in the coming year.

I was recently interviewed by Nicole Fende, The Numbers Whisperer ™ on her show SmallBiz Finance. Ms. Fende is a credentialed actuary, experienced CFO, former Investment Banker and President of Small Business Finance Forum LLC. Her weekly show is perfect for small businesses, start-ups, entrepreneurs, solopreneurs and independent consultants.

We discuss the origins of Creative Capital Associates, what is factoring, how it works and why it may be valuable. You can hear our 30 minute conversation here.

One of the issues you must consider when it comes to invoice factoring as a potential business financing tool is knowing your profit margins. Whenever you pay interest on capital you secure from outside sources, like a factoring company, you must first determine whether you can afford the added expense. It is a good idea in any case to know exactly how much profit you derive from each sale you make. If it is a product oriented business it should be relatively easy. Deduct the cost of the product before sale from the sales price minus all the incidentals; shipping, taxes, commissions, business overhead etc. It is also a good idea to work with your accountant to get a fixed percentage of the sale that represents your “overhead costs” such as rent, utilities, office handling.

With a service oriented business it is slightly different, but if you treat an hourly wage as a product you can get an idea of the costs involved with your jobs. Another benefit of going through this exercise is figuring out exactly what it is you do that is the most profitable. Obviously you want to focus on activities or products that are have the most profit potential. When using receivable factoring, the discount rate for providing the cash flow to help you grow your business will be an added cost against the net profit we are discussing here. For example if your company is a high volume low margin enterprise, factoring may not be suitable financing. So knowing what your profit margin is will allow you to make the right decision when thinking about using an invoice financing as a tool for growth.

Many invoice factoring companies require a due diligence fee. Although we do not, due diligence is when the accounts receivable financing company checks the background of their prospective client. This includes checking for any existing liens on business assets, unpaid taxes, owner background checks, and can even require, in some instances, the work of an attorney to review contracts between the potential factoring client and its customers. These reports and services are outsourced to credit companies and professional firms that specialize in providing this type of information.

Generally a factoring company can incur anywhere to $1,000 - $2,000 to close a new factoring account. Some factors require an up-front check with an application, while other factors take an agreed upon fee out of the first invoices being financed. Those factoring companies which do charge are only recouping a portion of the charges they pay to prepare for a factoring deal. Here at Creative Capital Associates we see the expenditure as part of developing an interest in our business relationship.

The phone keeps ringing, the emails keep coming, but we need to agree on some basics.

A factoring company provides financing by making advances on invoices to creditworthy customers. An invoice is defined as a product or service that has been delivered or completed (100%) and accepted as due by the customer.

- So if you need money to open a restaurant – a factoring company can’t help
- Any type of retail store that sells to consumers – maybe try a home equity line
- Need money for Anything related to real estate property – again, not for a factoring company
- You’re an agent who wants money in advance of commissions - there are a few specialty places that do that, but generally commissions are not “invoices”.
- You have a contract but need up front money to get it going – this is technically mobilization capital
- Your company has annual contracts and you want money today for funds that will be collected over the next year – a factoring company purchases 30 day invoices that cannot age more than 90 days
- No equipment, no inventory, no proforma or pre-billing
- And we definitely cannot pay to help a relative of a deposed government official from a foreign land.

When considering using invoice factoring for your capital needs remember it should only be used as a bridge to ongoing institutional (bank) financing. By factoring your invoices to get through a growth period you can effectively maneuver through the tough cash squeeze stage as the business gains momentum. Access to capital is key. Going to the bank too early can be hazardous if you don’t qualify for the proper financing facility which could leave you high and dry.

Accessing capital by factoring your commercial invoices is a valuable solution until you get enough critical mass to qualify for the size of loan to bring in stability. But factoring should only be considered as a strategy to get to the next level, not the end all be all of your financing needs. Factoring is a necessary step that brings credibility to your operation by showing that you have the required resources and capabilities to deal with commercial financing.

When I was younger I spent a lot of time around the music industry. Back then bands would set up in a garage and create demo tapes to send to clubs and managers. There were guys who worked at record labels called “A & R men” (artists and repertoire) whose responsibility was scouting for talent. I remember an important lesson I learned from one of these cats. His desk was always brimming with new cassettes from bands all over the country, so while he was on the lookout for a new star, he had to manage his workload by instituting a process that said – give me a reason to trash this tape.

For him, the reason could be the band forgot to rewind the tape, mislabeled it, didn’t provide good information, or just looked sloppy – whatever instant recognition it would take to pop the tape into the trash rather than the player. The lesson here as it relates to raising capital is make sure your executive summary or loan package is tight and well thought out.

Investors and lenders are busy people and do not like going down blind alleys that end up nowhere. The prospect might be well meaning, but if they haven’t gained enough insight into how the process of attracting capital works, they need to go back and do more home work. This is why businesspeople who have successfully raised equity capital or secured debt financing are going to have a leg up on the competition when it comes to funding a venture.

Marketing for money is another version of marketing for sales. The more you know and the better you execute will increase the chances of success. Make sure you always give the best first impression. In the capital markets when an entrepreneur is introduced and they are a jumbled mess, it telegraphs deeper issues regarding management and capabilities.

Here are a few tips;

1. Every single item you hand someone should have complete contact information

2. Go the extra step to use quality printing and paper materials

3. Tell your story in a expert fashion (which means have a story)

4. A reader should know in 3 sentences what they are looking at

5. Use your connections to find a good connection

6. Pay attention to the details, don’t slough over doing the extra work

7. Be on time – both figuratively and literally

This from a recent online Forbes article by Stephen Dunn;

Many a cash-strapped company fails to deposit its payroll taxes. Unlike other creditors, Federal and state taxing authorities are not at the company’s door demanding their money. The company resolves to pay the tax deficiencies later, when cash is available. Yet that day never arrives, and the problem only compounds. Eventually, tax collectors will appear and seek to collect the tax, penalties, and interest owing by the company. If immediate payment cannot be effected, the tax collectors will enter the company into an installment agreement. Liens in the company’s property arise in favor of the taxing authorities for the amount of the tax, penalties, and interest due them. The taxing authorities will record notices of their tax liens in the register of deeds’ office of the county where the company is located, disabling the company from selling or mortgaging interests in real property, and impairing the company’s credit. If the company does not cooperate with the taxing authorities, the taxing authorities will seize (“levy”) the company’s property.

It is a long article that explains how the IRS will hold owners of a company liable for unpaid taxes. Read the entire article here

Probably the most often asked question regarding receivables factoring is – what will my customers think? To be clear, this is a perception issue. If the factoring relationship is above board, it will be handled in an industry wide accepted manner with proper legal notification of the assignment of proceeds and verification of accepted invoices. This accepted manner is in place to protect all parties equally during an agreed upon transaction.

The critical issue is the perception. Trying to be sneaky about financing invoices is the wrong attitude. In fact, your company should be excited that an outside source of capital is willing to back your future success. By telegraphing this development in your growth it is unlikely a customer will have any issues with your decision to get the strategic capital alliance you need which will allow your company unhampered progress.

For the most part, very large corporations are very much aware of situations like lockbox payments and verifications coming through their accounts payables department. Giving advance notice of the relationship is all it takes to make invoice factoring run smoothly without disrupting customer relations.

A not so obvious distinction between different factoring companies is - where do they get their funding? The greater majority of factors borrow money from banks. This could have direct consequences by the time it comes down to you getting financed. Some banks require much more oversight in the operations of the factoring company. Issues like customer concentrations, credit ratings, credit insurance, security interests in contracts and corporations are just a few decisions that might travel through the factor and be regulated by the banking relationship. Usually if the factoring company has a stellar track record you will not see outright veto of funding decisions, but you could very well see parameters as to what is permissible or not.

You will find that the eccentricities of the financing relationship do not show up on the surface. It takes time for these sorts of problems to show up. Some factors are better at dealing with this than others.

Another potential liability in this economic climate is the sudden loss of a funding source. The factoring company you have relied on could lose their access to capital altogether leaving the entire portfolio without an ability to get necessary financing. In the invoice factoring community, this has been known to happen. Not frequently, but there are usually early signs of trouble that reflect something isn’t right.

By having a factoring company finance your invoices, your company is effectively leveraging their ability to borrow capital when you cannot. Borrowing from a lender comes either in long term qualities or short term realities. Once a business qualifies for a loan from a bank, for the most part a computer somewhere takes over the servicing of the loan. Meaning, the technology makes sure your monthly payments are made on time according to the terms fed into the program. The reason this works is the bank has determined there is stability in the operations and profitability so they can afford to take on the long term risk when making the loan. This is why the current commercial finance situation is so tenuous. Many businesses are having a tough time showing they have historical stability.

Factoring on the other hand is considered short term capital, meaning there is a very short leash for the borrower to get into trouble. By financing 30 day net term invoices, if trouble comes along someone will know about it within a couple months, which incidentally makes it easier to rectify. Because most factoring companies have much more leeway to work with their borrowing clients, things like unpaid invoices can be worked out through advances and reserves.

A key benefit of using invoice factoring is the ability to grow and not be hampered by credit availability. Unlike normal situations working with an institutional bank, which will only allow for a credit line based on historical profitability or tax returns, accounts receivable factoring only relies on you continuing to produce accepted invoices from creditworthy customers. So in other words, the factoring line grows with you and has no top end limit.

When a business is in a steep growth curve thanks to a new contract, it’s important to keep the access to capital open. Receivables factoring allows for wildly fluctuating revenues, strong months and then slow months. The emphasis is to use factoring as a temporary tool to build up a receivables asset base that will allow your company to qualify for a line of credit down the road.