By J. Chase Beakley
You might know everything there is to know about hauling frac sand, welding, or tank cleaning but if you can’t make sure that your customers’ pay schedules align with your own, then you won’t be able to keep your doors open, no matter how profitable your core business might be. And even if your cashflow rhythm is locked in, if the commodity market dips like it has recently, customers might start paying late or missing payments altogether, leaving you up a creek without a paddle.
Accounts receivable factoring can remove the guess work and ensure that you get paid in a timely manner so you always have enough working capital to operate. But every financial service comes with a price. Are the upsides of factoring enough to outweigh the costs?
What is factoring?
Factoring is a working capital service in which a third party, known as a factor, buys your accounts receivable invoices at discount. Usually, factors give you a majority of an invoice’s value up front, and then when your customer pays, they give you the rest of the invoice’s value minus a service fee. The amount that the factoring firm will advance you, and the cost of the service fee, varies depending on the pay schedule and the credit worthiness of your customers. If you do business with highly dependable customers like the government or large corporations, you could receive up to 90 percent of your invoices’ value as soon as the work is performed.
For example, say your company bills Drillers Incorporated for $100,000 of work on January 1, but Drillers Inc. can’t pay you until March 2. You could sell that invoice to a third party, a factor, for $90,000 and 1.5 percent per 30 days for the remaining $10,000. That means that your business would receive $90,000 on January 1, and then another $7,000 ($10,000 – $3,000 in fees) when Drillers Inc. pays the factoring company on March 2.
That $10,000 is kept back as a cash reserve in case there’s an issue with the work that was billed. If Drillers Inc. wasn’t happy with the job you did, they could refuse to pay the factoring company and you would lose the $7,000, at least until the situation worked itself out. Factoring allows you to pay a small fee for guaranteed cashflow security.
The Case for Factoring
Chris Curtin, Executive Vice President of Paragon Financial, says their factoring service provides plenty of bang for the buck. “Working capital, credit protection, accounts receivable management; those are things we try to resolve for our customers. And at 1.5 percent per 30 days, you’re getting a lot for your money,” says Curtin. Hiring a full time AR and credit manager at salary is a huge expense. For small businesses that are just starting out, outsourcing those tasks to Paragon might be well worth the service fee. In addition, Paragon provides working capital for companies that are “underbankable,” as Curtin puts it. Since factoring companies look at the credit of your customers, not your own company’s financials, they’re often able to offer credit when banks can’t.
Credit protection is another major pillar of Paragon’s service. Every factoring agreement is different, but in general when a factoring company buys your invoice they take ownership of the credit. That means that as long as the work that you’ve done is up to snuff, the factoring company will be responsible for negotiating late payments or non-payments. “The only thing worse than no sales, is doing sales and not getting paid,” says Curtin. Factoring can protect you from that risk.
Important to Consider
But for all of factoring’s advantages, it is not without its drawbacks.
First, let’s look at the cost. In the previous example, a company sells their invoice for 90 percent of its value and then receives an additional 7 percent after 60 days, with a fee of 3 percent subtracted. When it’s viewed as a financial service it seems reasonably priced, but when viewed as a 60 day loan, that 3 percent fee translates to 18 percent APR. Some proponents of factoring argue that a factor’s one-time fee can’t be compared to an interest rate, and that instead factors are buying invoices at a discount just like buying a product on sale. However, viewing factoring as a discounted sale of a product is problematic. When a shoe store discounts some of their sneakers it helps to drive sales and bring in more money for the business. Selling invoices to a factor is a cost for cementing your cashflow; it doesn’t increase sales.
It’s true that comparing factoring to a traditional financing isn’t completely fair. For one, a bank could never offer financing in the small sizes and turnarounds that factors can, and paying a large one-time fee is much less risky than taking on a loan with a high interest rate. But the criticism stands: factoring is expensive.
Lisa Hultz is the vice president of Mazon Factoring in Irving and says she understands how a potential customer might balk at the prices. “We totally understand—there are cheaper sources of financing. But I do try to be fair [to customers], and most people in oil and gas have good enough margins that they don’t bat an eye at our fees. Competition in the factoring space has brought down rates as well.”
Echoing Curtin’s statements about the amount of services factoring companies provide, Hultz said, “The hard thing is that people are comparing factoring to a bank, but we provide services and consulting. There’s a lot of work behind what we’re doing.”
Anyway you look at it, shaving 3 percent of your profit off the top of every sale is significant. And that’s assuming your receivables are creditworthy enough that you can qualify for the full 90 percent up front. Not necessarily a given for everyone. Factoring is definitely not right for you if you’re working with thin or inconsistent margins.
Another potential hangup for companies that factor is negotiating the transition from factoring to traditional financing. If you start a small business and factor your accounts receivable, you’ll have to arrange for the bank to buy out the factoring company in order for you to get a loan or open a line of credit. Depending on the financial stability of your customers and the particulars of the buy-out, the bank might not be willing to do that and your business could have trouble getting financing. Also, if you build your business around the consistent payment schedule that factoring provides, weaning yourself off can prove difficult. If your business is growing and you’re trying to get a loan that will help you reach the next level, the last thing you need is a major cashflow disruption. Most factors don’t require you to sell them 100 percent of your invoices, but the terms of the agreement and long-term outlook are important to consider before deciding to factor.
This transition can vary widely depending on the factoring company that you choose to work with. Some are looking for long-term relationships with established businesses, others love start-ups and are happy to help their customers transition to traditional financing when the time comes. Lisa Hultz says Mazon falls into the latter category.
“We’re here to help when you’re growing but when you get to the point that you can handle traditional financing, go for it. When it gets close to the time we’ll talk to the bank and negotiate the buyout agreement,” she said. Facilitating that change might seem counter intuitive but it has paid off for Mazon. According to Hultz, several of her customers have left to pursue traditional financing, and then come back to factor again when the circumstances called for it.
Sustained low commodity prices have impacted everyone in the oil and gas business, and factoring companies are not immune. Brian Whytlaw of Southwest Commercial Capital says their focus has been on helping their customers get back on solid ground. “Right now we are just trying to help our clients weather the storm of low-cost oil, as cashflow is more important now than in the recent years,” said Whytlaw.
Southwest Commercial Capital is an Odessa-based factor, and they bring a neighborly and localized approach to factoring. “I think we are unique in that we are a small company that is very hands-on with our customers and will try to work with our clients on any issues they have,” said Whyltaw. “My clients know my door is always open and they can always come to me to try to find a solution to any issue.” Factors tend to be more flexible and move faster than banks, and maximizing that competitive advantage is key to providing the best working capital solutions for their clients, especially in difficult cycles.
But despite the continued challenges facing oil and gas businesses, factoring companies tend to thrive when the market is in flux. When the market is stable and less risky, banks can come back and compete with factoring companies. Seizing on this opportunity is important but Whytlaw says it brings challenges as well. Understanding the client and their customers is critical and the biggest concern is ensuring that the debtor will pay the purchased invoices.
Big oil and gas companies are infamous for their proclivity to pay slowly, and with commodity prices seeming to remain low, that proclivity is only going to grow. It is certainly an expensive service but for small companies or startups that work with slow-paying customers, factoring could provide much-needed working capital for the road ahead.
Chase Beakley is a business journalist based in Dallas, TX. He can be reached via Twitter, @ChaseBeakley.