Businesses today have several options when it comes to invoice factoring. Non-recourse factoring is the second most popular option after recourse factoring. Also called bad debt protection, non recourse factoring can help you raise urgent working capital or cash flow for your business without having to take up a loan. All factoring options are not the same and all factors, funding partners or lenders are unique as well.
This guide will give you an in-depth explanation of non recourse factoring and everything a small to medium sized business should know about it.
Understanding Non-Recourse Factoring
Non-recourse factoring is the exact opposite of recourse factoring. Invoice factoring without recourse refers to an agreement wherein a business does not have to pay the factoring partner anything if invoice client, customers or debtors fail to pay their dues.
In simple words, if you choose the option of non recourse factoring to sell your customer invoices to a lender, and if the customer goes bankrupt or fails to make the payment, you cannot be held responsible for the bad debt. You won’t owe anything to the factoring partner. This is probably why most non-recourse factoring companies carry out extensive credit checks.
In contrast, if you sign a recourse arrangement you will be made liable for the collections if the factor is not paid within the stipulated time. You will also have to return any amount paid to you by way of advance. However, when you enter into a non-recourse factoring agreement, your business remains protected from bad debt.
Factors Considered By a Funding Partner
In non-recourse factoring, the risk of unpaid customer invoices is not shared between the factoring partner and business, like in recourse factoring. Hence, non-recourse factoring providers are more careful while doing business. They base their factoring arrangements on the following:
- Whether the customer has a high creditworthiness
- Whether the factoring partner has a credit protection program in place to offset any default customer invoices due to extreme events, like bankruptcy
- Whether the invoice packet consists of multiple customers to spread the risk
- Track record of the business with factor financing
How Does Non-recourse Factoring Work?
All factoring companies have their unique processes and requirements. However, there are a few pertinent things that are common among all of them. For instance, the process starts by agreeing to the factoring agreement. Your factor would purchase your accounts receivables by paying an upfront amount which will be a percentage of all the invoices combined.
This purchase of advance works like an asset for your business since you are effectively leveraging your business’ accounts receivables. You can use the advance amount as you would any other type of financing for extending your online business operations or expanding growth.
The agreement would include a clause stating the ‘initial factoring line’. This is the maximum amount of funds that will be advanced to you or made available to you by the factor through purchasing your customer invoices. This is similar to a line of credit. You cannot extend this amount.
The factor will pay the difference in the amount due and the advance paid to you once the invoice client pays up. Depending upon the terms of the arrangement, this amount may need to be paid in full before the factor can give you the difference amount. Any amount paid shall be minus the factoring fee, credit protection fee and non recourse assurances.
Features of a Non-recourse Agreement
All non recourse factoring agreements are unique. However, there are a few aspects that are similar in most arrangements. For starters, your lending partner would purchase your accounts receivables or customer invoices by paying a significant sum upfront. This is known as advance payment and can consist of up to 90% of the value of each invoice in the factoring packet.
However, this is seldom the case with non-recourse factoring. You would probably get about 70-80% of the invoice amount as your advance payment minus any factoring fee. This is because of the high level of risk in non-recourse factoring. Every payment is made on time as per stipulated time periods mentioned in the agreement. The difference due to you is paid by the factor in a timely fashion to your company as each invoice gets paid in full by the customers.
The factor would pay the difference amount as soon as your customer makes good on the amount owed in the invoice. The factor may again take their factoring fees, as per the terms of agreement, and pay you the rest of the amount owed.
Benefits of Non-recourse Factoring
It is important to understand the difference between factoring without recourse and taking up a loan for your business. Loan reflects as a debt on the company’s balance sheet. Whereas, when you use invoice factoring, you are essentially speeding up your cash flow by selling off or leveraging all or a portion of your accounts receivables assets that the company already has on books.
Bank loans focus on your business’ financial history and cash flow while factoring into the credit worthiness of your clients and how likely they are to pay the amount owed to you. Funding through selling off accounts receivables is not a loan and hence not exactly a liability. This allows your company to keep debt to a minimum on the balance sheet while keeping several lines of credit open at the same time.
Small businesses can benefit in a myriad ways besides keeping their debt to a minimum through non-recourse factoring. They can acquire immediate working capital or cash flow to scale their operations. They can pay off their suppliers quickly. By working with a dedicated funding partner, you could effectively outsource the collections process. The factor will be responsible for operational costs associated with credit assessment and collections.
In addition, you can effectively outsource the risks associated with your accounts receivable as well. You don’t have to worry about your customers experiencing extreme financial conditions, such as bankruptcy. Your non-recourse funding partner shall bear the losses leaving you free to enjoy the proceeds.
Costs Associated with Non-recourse Factoring
Many business owners are confused between recourse and non-recourse factoring. One major area where they both differ is the costs associated with them. Factors that do not have a strong client portfolio will charge a higher rate for additional risk, also called CPE or Credit Protection Element. Their factoring fee will be more for non-recourse factoring as opposed to recourse factoring. In contrast, a funding company that has a wide and robust portfolio may not fear taking on more risk.
They would be more interested in acquiring more business and a diverse accounts receivable portfolio. As a result, they may offer the values of non-recourse factoring without passing on any of the associated additional costs to their clients. It is important that you understand all terms of an arrangement before agreeing to it. You should pay special attention to the fee clause since that is the only way a factor makes money by doing business with you.
Who Should Consider Non-Recourse Factoring?
There are several industry verticals that can benefit by factoring their invoices. Invoice factoring or discount factoring allows businesses a certain leverage to enjoy immediate cash and scale their operations. However, it is important that you take the time to understand all calculations. All factoring providers charge a certain amount of fee called factoring fee. You need to know whether the sum you receive is worth all the trouble or not.
You will not be paid in full. You will not get the entire amount of your customer invoice bills. The factor shall keep a certain percentage of it as fee. This makes non-recourse factoring suitable for all businesses that have a wide profit margin. They sell their products or services at enough profit to absorb the amount charged by the funding partner and still make a profit.
This is why startups that have an established queue of backorders do well with non-recourse factoring. They can absorb the additional costs as long as they can raise enough working capital to stay in business and grow. Companies that do business with creditworthy clients can also benefit from non-recourse factoring. Businesses looking for competitive financial rates that get turned down by traditional bankers may find factor invoicing in general useful.
Experts claim that fast growing companies that have monthly sales in the range of $25,000 – $3,000,000 can find non recourse factoring beneficial. Industries and businesses experiencing the following may also benefit from non-recourse factoring:
- underperforming banking relationships
- bank exiting
- bank turndowns
- volatile cash flow
- additional funding required for materials for production or maintaining substantial inventory
- long-duration sales cycles
- seasonal sales
- slow-paying customers, like government agencies or large corporate buyers
- urgent or unanticipated customer demand for products or services
- funding required for investing in new equipment or technology
- funding required to broaden base by acquiring new production workspace, offices, or inventory warehousing
- opportunity to expand into emerging markets.
These are just a few business conditions where invoice factoring can come in useful. You should get in touch with a funding partner if you feel non-recourse factoring could be beneficial for your business.