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When the vice president of a Reston high-tech firm arrived at his home office after a Las Vegas trade show, he was exuberant. The three-day show had been a smashing success, and he was looking forward to developing a solid roster of new clients from the product orders he'd received. But fulfilling these new orders meant more supplies needed to be purchased, employees would be working overtime, and shipping and handling costs were about to skyrocket.

The vice president actually had a dilemma on his hands despite his Vegas success. Instead of launching into a new level of sales, he would need to spend the next few weeks looking for capitalization while holding off expectant customers. The vice president turned to a little-known capitalization vehicle for help. Unable to borrow from a bank, he went to an entrepreneurial factor for the capital he needed. Using the completed Vegas orders as collateral, he quickly secured the cash needed to fulfill customer expectations. And as it turned out, fulfilling the Vegas orders led to the high-tech company being able to establish itself with a banking institution to avoid ever being short of capitalization again.

How is it done?

But what was the "entrepreneurial factor," and how common – and safe – is it to do business with this kind of finance provider?

The practice of factoring has literally been around for thousands of years. Whenever someone is owed money, there has always been someone else willing to take a cut of future income in exchange for providing "instant relief" to the owed party. The most common example of a modern receivable finance vehicle is the credit card. A merchant gets paid by the host bank before its customer gets around to paying the bill, and the bank takes a percentage of the customer's payment.

The factor works in similar fashion, providing capital either by purchasing the asset value of a receivable (non-recourse) or by making a loan with the invoice as collateral (full-recourse). When the factor purchases the value of the receivable, it takes the credit risk that the invoice will be paid, while the client retains the performance warranty on the work done for the customer. The factor usually performs a credit check on the customer before deciding to purchase the receivable. When a factor makes a loan against an invoice – which typically occurs when customer credit is not favorable – its client continues to assume the credit risk, and will be liable for non-payment.

How common a practice is this?

Since the factor often helps provide financial discipline and for its clients, it isn't uncommon for a bank to recommend a factor to a client seeking a loan without the adequate credit record. Banks see factoring as an interim solution to inadequate credit. And even institutional banks have begun to offer the kind of lending services normally associated with factors — accounts receivable financing.

"Sometimes a company can't pursue conventional financing," says Michelle Douglas of Southern Financial Bank. "Factoring allows companies the opportunity to secure short-term working capital to get them in a better position to secure a banking relationship."

An honest – and smart — factor wants its client to eventually graduate to conventional banking relationships. A company which cannot establish an exemplary credit history can eventually become a bad risk for any financial partner. The factor's ideal partnership would be with a new or reorganized company with a bright future – one which probably won't include depending on a factor for more than limited period.

How does the perception affect a business?

"The general misconception is that the only time to use a factor is when your company is going out of business" says Gary Honig, President of Creative Capital Associates, a Maryland-based factor. "Exactly opposite is the truth: Factors want to work with companies in a growth mode. They are as unlikely as any financial institution to invest in a failing company".

The perception of the factor as the last line in a shaky financial defense has persisted largely because of the unregulated status of the factoring industry. Some factors are private individuals with huge cash bankrolls, while others are public companies accountable to shareholders. Until recently the use of a factor was thought to indicate that a company had fallen to the bottom of the financial pecking order.

What has changed?

But the factoring industry itself is in a growth mode, and the marketplace is shaking out the shady players through a combination of competition and sound operating procedures. The factors watch each other closely – they interact constantly, providing assistance to one another as banks do – and they aren't shy about comprehensively learning their clients' business and industry. Some factors often specialize narrowly, dealing with just medical or construction receivables, for example. And while they often deal with companies unable to make a deal with conventional bankers, the typical factoring company doesn't take on all comers. Far from it. Since it will operate as a de facto partner or investor by assuming the risk of a company's receivables, it's in the interest of the factor to take on clients who are growing, solvent, and ambitious.

"It's critical to work with a factor who understands you and your business plan," says Honig. "Most factors aren't willing to take on just anybody, and you should be wary of any factor who gives the impression that they're willing to business with everybody. Normally, you shouldn't use a factor beyond the growth spurt that initiated the need for one. You use a factor to get to better terms."

And terms, of course, vary greatly.

The factor generally discounts the full face value of an invoice by a certain percentage. Rates are generally determined by risk and volume. High risk is more expensive, low risk less expensive. Low volume, measured in dollars per month financed, is more expensive, high volume less expensive. If a client can guarantee it will need factoring for a specific amount of either time or money, the rate can also be lowered. Some factors provide annual APR rates which are tied to the amount of financing outstanding, while others simply discount invoiced amounts between two to six percent.

Partly because of its unregulated nature, it is rare to find two factoring companies which operate entirely alike. Each factor has its own method to sort out credit issues, notify a client's customers, and verify that invoices are real and collectable. Some factors will also operate as a collection agency.

So what's the good news

Even hardcore skeptics of factoring admit there are some unique benefits to the practice. First and foremost is equity, which remains unchanged on the company balance sheet even when deals with a factor are struck. A conventional bank loan or credit line shows as an on-going liability on company books. Also, entering into a relationship with a factor – and getting capital — takes only a few days. For companies wrestling cash flow crunch, the immediacy of potential capital is often the deal-maker.

"We've been operational for over twelve years, and recently we got into a pinch due to some new and large accounts," notes Doug Beaver, owner of Gaithersburg-based Amguard Security Services. "Rather than going through a total re-application of our bank line, we used a factor for short-term working money until the new accounts became self-payable. Having never used a factor before, I was surprised how quick and painless the process was."

But no aspect of the factoring business is as highly regarded as its flexibility. Compared with the usually rigid practices of both your neighborhood and downtown bank, a factor can be just the fresh opportunity a business needs to blossom.

"Our business grew ten-fold in less than two years," says Anthony Wright of Virginia-based P&W Surplus Office Movers, "And factoring allowed us to sustain that kind of growth. It gave us flexibility."

By Sean Harris

Mr. Harris has been widely published in newspapers worldwide (Washington Post, Baltimore Sun, Seattle Times, Montreal Gazette, Toronto Globe & Mail, London Times, Houston Post, etc.), and has written about information technology and DVD for a variety of national trade magazines (Information World, the SIGCAT Discourse. Etc.). He is the Creative Director for the PR and marketing company Pink Piglets Ltd., based in Washington D.C.

At various times in the life of a company there will be requirements for outside assistance in order to grow the business. One requirement will be the need for additional capital. Choosing which financing vehicle is best for your company is very important. It’s choosing the right tool to fix the problem.

Deciding whether to seek equity capital or debt financing is the first step. Usually companies trying to get equity capital are very early stage with little or no real assets. While companies on their way to a steady growth curve use debt financing.

The equity route

As the owner of a business idea, plan, or company – you hold ownership to a subjective value called equity. The equity of any type of property whether intellectual or physical is the value someone is willing to pay for it minus any liability attached to it. In business that could mean the value of an entity today measured in time and money invested versus the value in the future measured by comparable growth.

Once the owner and investor determine the “valuation” of the equity, the owner can then sell parts of the equity in order to raise capital. There are a variety of methods you can raise equity capital (Seed, Angel, Venture) and you should learn the pluses and minuses for each. An equity capitalist is interested in picking a company that shows great potential. They are expecting that there will be significant growth due to their involvement. That could mean that the company will grow tenfold within five years.

Without a doubt, first and foremost on any equity capitalist’s due diligence list will be the management team. Even before the idea itself, it is commonly stated, great idea’s with a bad team will get nowhere, whereas, bad idea’s with a good team still have a chance to make it big. You should also realize, that once invested, the equity capitalist will be having an active role in the decision making of the company. Because they have “bought in” to your company they are now your partners, how active they become needs to be sorted out up front.

On the debt side

Conversely, raising capital through debt financing does not entail “selling” your equity, but instead works by “borrowing” against it. Debt financing is only available to business owners who have something of value that the lender can instantly liquidate. The debt finance company is not interested in becoming a partner in your endeavor, instead they are in business to make money from their money, letting you use it for periods of time.

Like equity financing there are a variety of methods available to raise debt financing. Traditional banking will always be the least costly source for your financing, but remember bankers are not in business to take on risk. When they ask for three years of company tax returns its because they want to see a steady reliable set of profitable growth numbers. Borrowing from the bank relies on two variables, the collateral that secures the loan, and your ability to repay the loan. You might have enough collateral, but if your business is losing money, the bank can’t expect you to handle the added expense of loan payments.

Many early stage companies turn to private commercial financing which is better suited to deal with riskier issues. Factoring companies use the loans you make to customers (invoices for finished work) as the collateral for their funding. Here the emphasis will be the creditworthiness of your customers rather than the credit of your company. Equipment leasing companies will allow you to purchase new equipment and pay for it over time, usually three to five years.

Finally,

When seeking outside capital, whether equity or debt, remember that certain sources are familiar and like to work with particular industries. Take the time to look around and be sure that the source you are considering is well-aquatinted with your type of business.

- article appeared in the Business to Business Newspaper of Howard County & Columbia MD.