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Factoring: What, When, and Where

What, When, and Where about Factoring

In order to make a well informed decision on using factoring services, a CFO must understand the factoring product, truly if you do not; your company should not be using it. But to understand the factoring product, examine it from several perspectives. When you know the what, where, and when to factor, you can answer some of those basic questions.

What is Factoring

Factoring is the purchase of qualified Accounts Receivable or invoices by a factoring company from an operating business in order to provide immediate Cash Flow to that business. Most factoring Purchase Lines allow for you to sell your invoices at 80 to 85% of face value up to a 45 day period from the invoice date. Typically, you can age the invoices up to 90 days from the purchase date before you must buy them back from the factoring company.

Some factoring companies collect your invoices for you and some do not. Some banks allow for you, the client, to collect your own invoices, and use their treasury management services as a mail box for the collection of the invoices. Pricing is typically based on the risk of the deal, size of the deal, and the volume of invoices sold each month. Finding the proper factoring company with the best pricing and the ability to create a strong banking relationship is as important as the characteristics of the deal. That is why the banks have been so successful with their product. They offer the best of both worlds: very competitive pricing and the ability to develop a long term banking relationship.

When To Factor

Deciding when to factor may be the easiest decision to make in the factoring equation. Any transitional need in a company can create a factoring situation. High growth is usually the most common in the Texas market, however, lack of capital, high debt leverage, payroll tax problems, or just not being able to meet your payables within their terms are all reasons for using the factoring product. Always, the primary goal is to increase your cash flow and allow you to smooth out the up and down swings which are created by clients that do not care to pay their bills in a timely manner.

The time value of money becomes critical in these situations, and it seems to be the norm that the larger the client, the slower they pay. This is especially true in the staffing industry where payrolls must be met on a weekly or bi-weekly basis. But clients pay in a 45 to 60 day period subsequent to receiving their bill. Whatever the reason, cash flow is the key element in building and growing a strong business, and if this is your hope for the company you represent as a CFO, then factoring your receivables could be the answer.

Where Should You Factor?

Deciding where to factor is probably the hardest decision to make once you have concluded that factoring may be the answer for your company’s needs. There is a variety of independent and bank owned factoring companies to choose from, and they all have their own cash flow programs. Coined phrases for cash flow solutions are the norm, but keep in mind that there are many differences to their services. Commitment fees, exit fees, delinquency fees, and then standard “factoring fees” all contribute to your cost for the service. Many companies prefer bank owned and operated factoring programs because of the banking relationship it creates and generally lower rates due to the bank’s low cost of money. However, some prefer the service you get from the smaller, independent factoring companies. But keep in mind that you generally pay for that service.

Review Legal Document

Regardless of what type of factoring company you pick to purchase your invoices, always review with a keen eye the legal documents, they will tell the story on the cost of the service. Make sure you have a thorough understanding of the rights of the factoring company and the control they have over the cash flow of your company. Many times you can negotiate away the extra fees, but you must ask. These fees can include the exit fee and the delinquency fee.

Involve Legal Counsel

Also, you may want your legal counsel or your CPA to take a look at the agreement to better define the ramifications for issues that naturally occur in your business, but may not be in accordance with how the program works, like having 60 day payment terms to some of your customers. This small, insignificant issue could put you in default of the Purchase and Sale Agreement and result in higher factoring charges to your company. Clearly, having your council review these documents prior to their execution could save you thousands down the road.

Ask for References

Lastly, a real acid test for a factoring company is to ask for references, and find some clients that are no longer with the factoring company, as this could tell you volumes on how they treat their clients, and how well their services work on a day to day basis. Good factoring companies should have no problem allowing you to check them out. Since factoring is largely unregulated, you owe it to your company to do at least this much due diligence. Good luck and may your cash flow freely.

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See Also:
Another Way To Look At Factoring
Accounting for Factored Receivables
Journal Entries for Factored Receivables
Can Factoring Be Better Than a Bank Loan?
Factoring is Not for My Company
History of Factoring
How Factoring Can Make or Save Money
What is Factoring Receivables

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Term Loan

See Also:
What is a Term Sheet?
Term Deposit
Terms of Sale
Below the Line
Lease Term

Term Loan Definition

A term loan, defined as a loan which exist for a specific, predetermined amount of time before it is called and requires payment, is a staple in the loan industry. A term loan contract defines the period of time when the loan must be repaid. The agreement for this is negotiated and signed by both lender and receiver.

Term Loan Explanation

A term loan, explained as a loan that exists for only a certain period of time, is one of the many types of financing for a business. Most loans, regardless of type, have some sort of time when they are expected to be repaid. A term loan agreement, in comparison, establishes the period which the loan remains open as part of the agreement. There are both short term and long term loans. Short term means less than 1 year. Long term, on the other hand, means greater than 1 year. These loans maintain interest, principle payments, fees, and other requirements just as non-term loans do.

Example

For example, Kevin has started an A/C and heating company. He has worked to the bone to establish his company. He has gained accounts receivable, clients, some assets, and quality employees. Now Kevin must continue to grow his business. To do this, he needs financing.

Kevin has evaluated his options and now sees a term loan as his best financing opportunity. He makes sure to know what he wants and expects from the loan before he schedules a meeting with agents. Kevin will plan now rather than paying later.

When Kevin meets with the bank they negotiate an interest rate, principal payment schedule, and other details. With this he also negotiates a term loan amortization schedule. He decides on 5 years; ample time to repay. He also arranges for no penalty for early repayment to Kevin has flexibility in his loan. He leaves the meeting confident that he has made a good situation for his business.

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Subordinated Debt

See Also:
Mezzanine Debt Financing (Mezzanine Loans)
Collateralized Debt Obligations
Outstanding Debt
Self-Liquidating Loans
Loan Term
What Your Banker Wants You to Know
Alternative Forms of Financing

Subordinated Debt Definition

Subordinated debt is a security which has a residual claim upon a company’s assets, after the senior debt holders have had their claims satisfied.

Meaning of Subordinated

Subordinated debt is usually taken on by a company who cannot reach better financing opportunities. Whereas, subordinated debentures often contain a higher interest rate due to the risky nature of the securities to investors. Investors would simply refuse to take on a security that has a residual claim on the assets unless the company were willing to pay more. This is also why many companies use this as a last option in financing because of the high costs involved.

Subordinated Example

For example, Parent Co. made an acquisition of Subsidiary Co. a year ago in a leveraged buyout (LBO) for $100 million. They were able to gain a loan from the bank with low interest rates at 5% for $75 million, and was offered a Line of Credit for $50 million. Parent Co. has recently had some trouble cutting costs and getting Subsidiary to run smoothly. Thus, they have used up the rest of its line of credit.

Parent Co. is looking to go public with an IPO soon. But they need financing now to stretch the company until it is able to provide a public offering. Therefore, Parent Co. receives subordinated debt at a rate of 8% for another $50 million. This is at a higher cost to the company/. But they can use it to postpone the debt woes until the company is able to make a public offering in the market. They can then use equity money to pay off the subordinated securities as well as the line of credit.

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Secured Claim

See Also:
Pledged Collateral
Collateralized Debt Obligations
Debt Ratio Analysis
Debt Service Coverage Ratio (DSCR)
Convertible Debt Instrument
Asset Based Financing

Secured Claim Definition

The secured claim definition is debt backed by collateral. It can refer to loans, mortgages, bonds, and other financial debt instruments.

As stipulated in the debt contract, the debtor backs the debt with assets that the creditor may claim in the event of default. In a secured claim contract, if the debtor defaults, or is unable to payback the debt, the creditor can take ownership of the collateral and sell it to pay off what the debtor owes. For example, if a consumer defaults on a mortgage, the bank can claim the house and sell it to pay off the consumer’s debt. In the event of default, the secured claim is worth only as much as the collateral that backs it.

In contrast, unsecured claims are debt contracts or instruments not backed by collateral. Secured claims are considered less risky. In addition, these contracts or instruments offer lower yields. In comparison, unsecured claims are more risky. These contracts or instruments offer higher yields to compensate the lender (or investor) for the higher risk.

secured claim

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Mezzanine Financing

See Also:
External Sources of Cash
What Does A Lender Want To Know
Finding The Right Lender
Due Diligence on Lenders
Weighted Average Cost of Capital (WACC)

Mezzanine Financing

A mezzanine lender, provider of mezzanine financing, functions similar to a bank in terms of providing a source of capital for companies. They get their capital from private investors who look to make a profit off of the investments the mezzanine lenders make. Often times, the firm is structured as a limited partnership for tax purposes.

There comes a time in every company’s life cycle when the company and/or the entrepreneur need some more cash. Perhaps the company needs more working capital or some additional money to help fund an expansion. Or, maybe the entrepreneur feels that it’s time to reap the benefit of all those years of hard work. Whichever the case may be, the entrepreneur will be faced with many different financing options. An interesting and often over-looked option is that of bringing in a private equity partner in the form of mezzanine funding.

Mezzanine Lenders

Mezzanine lenders are similar to banks … but they are not banks. The interest they charge is going to be higher than what commercial banks charge. Many entrepreneurs blench at the thought. But consider, other than maxing out your credit cards, what other alternatives do you have? Mezzanine lenders will charge you approximately what credit cards charge you. Their cost of capital ranges from the high teens to low twenties (18-23%). This may seem quite high, but if your enterprise is so risky that a bank will not touch it, then it is only fair that someone be rewarded for taking on this extra risk. Also, what bank would feel comfortable about an entrepreneur taking the bank’s money and pocketing it for personal gain? No bank would. Mezzanine lenders do.

Mezzanine lenders can also benefit the firm in other ways as well. They can help entrepreneurs upgrade their talent resources by finding professional management staff. They can help with finding better technology, placement with new customers or help you find sourcing alternatives. Remember, the best business partner is someone who brings more than just money to the table.

Financing typically comes in the form of either a loan and/or equity interest. Sometimes the debt is convertible into equity. Many people worry when they hear that their equity is to be compromised. This is actually not so. Mezzanine lenders are open to having their equity interest bought out. Think of it as a “pop” for taking on the risk.

Mezzanine Capital: Purpose

Let us consider a common business dilemma: 1) lack of working capital or 2) lack of funds for capital expansion. Entrepreneurs by nature are optimists and passionate people, especially when it comes to their companies. They want and need a financial partner that can grow with them. Typically, your first option of choice is your friendly, neighborhood commercial bank. There are several issues that one often encounters here:

1. Debt – Is your company too leveraged for the bank to accept?

2. Profitability – Is there enough profit to sustain the enterprise?

3. Cash Flow – Is your company generating enough cash to pay the bills?

4. Inventory – Are you turning it over fast enough?

5. Equity – Do you have enough skin in the game?

If your firm can pass the litmus test, then by all means you should go with your friendly, neighborhood commercial bank. They are typically your cheapest source of money.

Next, let us consider a more interesting question from the entrepreneur’s perspective. I’ve worked this long and hard. Don’t I deserve to be rewarded? Don’t I deserve to be a millionaire? If you don’t already have a million dollars in the bank, then the bank will probably be the first to tell you, “No.” So what’s a hard-working entrepreneur to do? Surprisingly, this issue is one that is faced by countless business owners as they face retirement or just want to “take some chips off the table” for security purposes.

The above cases represent typical situations where it makes sense to consider other financing options such as a Mezzanine Debt Financing.

Recapitalization Example

Below are some typical scenarios where you might want to consider working with a mezzanine lender:

1: Company needs capital infusion for either working capital or CAPEX.

2: Entrepreneur would like to buy out a partner.

3: Entrepreneur would like to “take some chips off the table” to provide security for his/her family.

4: Entrepreneur would like to pass along management to next generation.

5: Entrepreneur would like to share some equity with management staff and/or employees.

6: Entrepreneur would like help with selling the company to a strategic buyer at a good profit so s/he can retire.

Mezzanine Recapitalization: Conclusion

Entrepreneurs should consider mezzanine lenders a strategic financial resource. They many not always be your first choice, but they just might be your best choice. They have a higher cost of capital than banks. But, for the money, they provide a lot of strategic options to the entrepreneur that commercial banks could not be party to.

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Reorganization Definition

See Also:

Debtor in Posession
Financial Distress Costs
Insolvency

Reorganization Definition

Reorganization is when a bankrupt company restructures its debt obligations without going out of business. During reorganization, the debtor retains ownership of its assets and continues business operations. The debtor then renegotiates the terms of its debt obligations to creditors. If a company is having financial trouble and is at risk of defaulting on loan payments, that company may want to consider reorganization to consolidate debts and adjust loan agreements to make payments more manageable.

Reorganization vs. Liquidation

Reorganization and liquidation are two types of bankruptcy processes. In a reorganization, the debtor retains ownership of its assets and continues business operations while renegotiating debt repayments with creditors.

In a liquidation, the creditors seize control of the debtors assets and sell them to pay off the debt. Furthermore, the debtor goes out of business and ceases normal operations. After liquidation, the entity technically no longer exists.

Chapter 11 Reorganization

Chapter 11 bankruptcy is a type of bankruptcy proceeding outlined in the Bankruptcy Code. It is also a reorganization procedure.

When a financially distressed entity files for chapter 11 bankruptcy, the entity continues to operate while it restructures its debt obligations. The entity is given a limited amount of time in which to restructure the debts. During this time the entity is protected from creditors.

Reorganization bankruptcies are usually more complex than liquidation bankruptcies. Companies usually file for Chapter 11 bankruptcy.

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Reorganization Definition

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Passthrough Securities

See Also:
Collateralized Debt Obligations
Secured Claim
Subordinated Debt
Mezzanine Debt Financing (Mezzanine Loans)
Asset Based Financing

Passthrough Securities Definition

A passthrough security is a debt obligation that represents the cash flows towards a certain asset or liability. There is often an intermediary between the cash flows and the investor who provides a lump sum many times to receive several cash payments in the future.

Passthrough Securities Explained

Passthrough securities are similar to asset-based financing; however, asset based financing involves using an asset like land for a loan. Whereas a passthrough security simply passes future cash flows onto an investor. Some of the most well known pass through securities were involved in the recent financial crisis. These are regularly known as mortgage backed securities (MBS) and asset backed securities (ABS). Furthermore, these securities simply take the future mortgage or asset payments toward a certain asset and sell them in the market for a lump sum. As a result, a company can see more cash or liquidity up front. Notice that the passthrough occurs between the person making the payment to the bank or financial institution, and the financial institution then providing this cash to the investor. In most situations, a bank will assume the role as a passthrough entity.

Passthrough Securities Example

For example, Money Bank specializes in the real estate market and provides financing to individuals buying houses. In order to stay liquid and keep providing loans Money Bank groups the mortgages it has obtained every quarter and sells them in the marketplace at a discount. Bob is a wealthy investor and wishes to invest in something that will provide him a meaningful return. Bob comes across the passthrough securities provided by Money Bank and decides to purchase some of the pass through securities. Both parties have benefited because Bob is earning a meaningful return while the Bank has received liquidity and can now provide more real estate loans.

Passthrough Securities

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