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• 25 Oct

  Understanding Your Factoring Agreement

  An Introduction To Understanding Your Factoring Agreement

  Factoring agreements are the legal documents that regulate the factoring arrangements between a client and a factoring company (or factor). It is important to fully understand any agreement before you sign it or enter into a binding contract.

  WARNING: YOU SHOULD SEEK LEGAL ADVICE FROM A SOLICITOR BEFORE ENTERING INTO ANY LEGAL AGREEMENT. THIS ARTICLE IS FOR INFORMATION ONLY AND IS NOT INTENDED AS LEGAL ADVICE.

  

  Introducing Factoring Agreements

  Invoice factoring facilities have become an essential financial tool for many UK-based companies. They provide businesses with immediate cash flow by selling their invoices to a third party, known as a factor.

  Like any financial agreement, it's crucial to understand every aspect before diving in. This article aims to shed light on the intricacies of factoring agreements, ensuring that UK companies make informed decisions.

  COMPARE FACTORING QUOTES NOW

  What Is A Factoring Agreement?

  A factoring agreement is a contractual arrangement where a business sells its accounts receivable (invoices) to a third-party company (the factor) at a discount. This allows the business to receive immediate funds rather than waiting for clients to pay their invoices. A factoring agreement normally includes credit control support from the provider. See our free Guide To Factoring.

  Agreement Structure

  The agreement may be structured in different ways depending on the factor that you are dealing with. In some cases the agreement is little more than a single-page contract, in other cases, there may be several documents (that may be combined into a single legal contract in some cases) such as:

  • The offer letter - this is normally a summary of the key terms of the facility, e.g., the fees, funding structure and security required. Often, this will form part of the agreement. See our article about comparing factoring quotes
  • The factoring agreement - the full terms and conditions that will regulate the arrangement
  • Personal guarantees or warranties - documents to establish PGs or warranties (normally from the company's directors)
  • Other supporting documents such as a tariff of charges or documents to establish a debenture or charge over either the book debts or other assets such as property 

  In some cases, the documentation may be handled electronically without having a physical agreement or wet ink signatures.

  The Different Types of Factoring

  See our full explanation of the different types of factoring facilities to fully understand how the facility type can vary. You should also see our comprehensive guide to invoice financing which covers all aspects of how these facilities work and what they cost.

  Key Components of a Factoring Agreement

  The agreement will set out the terms by which the facility will operate. It will include detailed provisions regarding the funding, charges, operation and termination of the arrangement.

  

  Some key aspects include:

  Advance Rate And Deductions

  This is the percentage of the invoice amount the factor will provide upfront and any funding restrictions or deductions that may be subtracted. For instance, an 80% advance rate on a £10,000 invoice would mean the business receives £8,000 immediately (less any deductions).

  Discount Rate (or Factoring Fees)

  This fee is what the factor charges for their services. It can be a flat fee or a percentage of the invoice amount and a separate charge against the funds drawn down. See our guide to how pricing works. You should shop around to ensure that you get the best pricing for your circumstances. Here are our Top Tips For Getting A Good Price

  Duration of the Agreement

  Factoring agreements can be short-term or long-term. It's essential to understand the duration and any penalties associated with early termination and the period of notice required to terminate your facility. For more information about moving receivables financing companies see our free guide.

  Reserve Account

  After collecting the invoice amount, the factor will deposit the remaining balance (after deducting their fees) into a reserve account. This account is then used to settle any discrepancies or chargebacks.

  Understanding your factoring agreement is crucial for any UK-based company considering this financial tool. It offers a solution to cash flow challenges but comes with its set of considerations. In the next sections, we'll delve deeper into the intricacies of these agreements, ensuring that businesses are well-equipped to make the right decision.

  The subsequent sections will further explore the nuances of factoring agreements, including the legal implications, best practices, and real-world examples from the UK market.

  Delving Deeper into Factoring Agreements

  The Legal Implications of Factoring

  Factoring agreements, like all contracts, come with legal obligations and implications. It's essential to be aware of these to avoid the potential pitfalls of factoring agreements.

  Transfer of Rights

  When you enter into a factoring agreement, you're transferring the rights of the invoice to the factor. This means the factor legally owns the invoice and has the right to collect the debt.

  Confidentiality Clauses

  Some factoring agreements come with a confidentiality clause, ensuring the factor doesn't disclose the arrangement to your clients (except in certain circumstances). This can be helpful in maintaining business relationships if you are concerned about retaining customer contact.

  Recourse vs. Non-recourse Legalities

  Recourse factoring means you're legally obliged to repay the factor if your client doesn't settle the invoice. With non-recourse factoring, the factor assumes the risk, but they might have specific conditions under which they can still hold you accountable.

  Security Pledged

  A very important aspect is to understand the scope of the security that you have pledged in support of the funding. This will include the book debts but it may also include giving personal guarantees (in some cases there may not be a PG required) or pledging other assets. Your solicitor will help you understand what these terms involve.

  Operational Considerations

  The agreement may set out how you can expect the facility to operate. This may include your obligation regarding the conduct of the account.

  Termination Arrangements

  This section of the agreement will set out the circumstances in which the factor can terminate your arrangement and the amount of notice you have to give them to terminate the agreement. You need to understand these aspects upfront as failure to comply with all your obligations could jeopardise your facility.

  Best Practices When Considering Factoring

  Thoroughly Vet Your Factor

  Just as factors will assess your business, you should also assess potential factors. Look for reputable companies with a track record in your industry. Consider looking at customer reviews or consult a reputable broker.

  Understand All Fees

  Beyond the discount rate, some factors might charge additional fees, such as account setup fees, money transfer fees, or overdue fees. Ensure you're aware of all potential costs - you should ask if there is a tariff of charges.

  Maintain Open Communication

  Regularly communicate with your factor, especially if you foresee any issues with an invoice. This proactive approach can prevent potential conflicts that could lead to termination.

  Real-World Examples from the UK Market

  The Success Story of a UK Healthcare Recruiter

  A small UK-based healthcare recruiter faced cash flow challenges in supporting their growth. By opting for a factoring agreement, they accessed immediate funds, allowing them to meet their operating costs and their payroll. The quick influx of cash allowed them to keep on top of their cash flow. See this recruiter case study.

  Challenges Faced by a Construction Company

  A UK construction company opted for factoring to fund its growth. However, they faced issues with the concentration restriction in respect of their single debtor. They were able to find an alternative provider that could offer a significantly increased customer credit limit. This enabled them to benefit from improved cash flow generated by the factoring arrangement.

  The Role of Technology in Modern Factoring

  Digital Platforms and Integration

  Many modern factors offer digital platforms that integrate with business accounting software. This seamless integration can simplify the invoice submission process and provide real-time updates on invoice status.

  Automated Credit Checks

  Technology has enabled factors to conduct rapid credit checks, ensuring that the invoices you submit are with creditworthy clients, reducing the risk of non-payment.

  Online Support and Resources

  Many factors provide online resources, tutorials, and support to help businesses understand the intricacies of their factoring agreement and maximise its benefits.

  Conclusions So Far

  Factoring agreements can be an excellent option for UK-based companies, but they require a thorough understanding and careful consideration. From legal implications to real-world examples, it's evident that while factoring can provide immediate financial relief, it's essential to approach it with diligence. Next, we'll explore how to navigate potential challenges and ensure that your factoring agreement aligns with your business goals.

  The next section will provide a comprehensive guide on navigating the challenges of factoring agreements and ensuring they serve as a beneficial tool for UK-based businesses.

  Navigating the Complexities of Factoring Agreements

  Overcoming Common Challenges in Factoring

  Every financial tool comes with its set of challenges, and factoring is no exception. Here's how UK-based companies can navigate these hurdles.

  High Fees and Hidden Costs

  Solution: Always request a detailed breakdown of all fees. Negotiate terms upfront and consider shopping around to find the most competitive rates.

  Strained Customer Relationships

  Solution: Opt for a factor that values customer relationships as much as you do. Confidential factoring of invoice discounting can also be a solution, where your customers remain unaware of the third-party involvement.

  Contractual Limitations

  Solution: Before signing, review the agreement for any restrictive clauses, such as minimum invoice amounts or long-term commitments. If any terms don't align with your business model, negotiate or consider another factor.

  Ensuring Your Factoring Agreement Aligns with Business Goals

  Short-Term vs. Long-Term Needs

  Determine whether you need factoring as a short-term cash flow solution or a long-term financial strategy. This will guide the type of agreement and factor you choose. In some cases, a spot factoring facility can allow you to pick and choose invoices to finance without being committed to submitting all your turnover for funding.

  Growth and Expansion Plans

  If you're planning to expand your business, ensure the factoring agreement provides the flexibility and funds to support that growth. Ensure that the facility ceiling is set high enough to accommodate your projected growth.

  Industry-Specific Factors

  Some factors specialise in specific industries, offering tailored solutions and insights. Consider the benefits of opting for an industry-specific factor if one is available for your sector.

  The Future of Factoring in the UK

  The financial industry in the UK is continually evolving and adapting to new challenges. Stay informed about any changes that might impact factoring agreements. This can include the launch of new, improved product offerings that might offer you additional benefits or cost savings.

  Technological Advancements

  As technology continues to advance, the factoring industry will likely see more automation, integration, and digital solutions, making the process even more seamless for businesses.

  Increased Competition

  With the growing popularity of factoring, more players are entering the market. This increased competition could lead to better rates and services for businesses. It is important to check your pricing and facility structure on a regular basis.

  Avoiding The Pitfalls Of Entering Into A Factoring Agreement

  This section sets out a number of the common pitfalls that businesses can encounter when they enter into a factoring agreement to improve the cash flow of their business. It also seeks to give some helpful tips as to how you can avoid these pitfalls when you enter into a factoring agreement. You can also read our article about alternatives to factoring.

  1.      Miss Use of The Funds Raised Through The Factoring Agreement

  The way that factoring works is that the business receives a pre-payment against the value of its outstanding sales invoices. The value of these invoices is the working capital of the business i.e. the funds that need to be used to pay suppliers, staff, expenses etc. One common misuse of factoring is that a company will take the initial payment received from the factoring company, which can be substantial, and use the money for some kind of capital expenditure such as the purchase of equipment or machinery. The effect of this is that a large amount of the working capital within the business is then tied up.
  
  THE ANSWER: The funds released through a factoring facility should be used as working capital within the business, if the business needs to raise finance to buy equipment or machinery, asset-based finance (leasing, hire purchase etc) that is more suited to this kind of expenditure and will have a much-reduced impact on working capital.

  2.      High Costs of Factoring

  As with any finance, there is a cost associated with accessing the funding and the facilities of some factoring companies are expensive, particularly when compared with their competitors.

  THE ANSWER: If the business shopped around and sought several different quotations, it is possible to find some very reasonable deals, it is just a case of knowing where to look!

  3.      Choosing The Wrong Factoring Company

  It may appear that there will be no difference between factoring companies. Many people see factoring similarly to how they see their mortgage, once the finance is in place then it just ticks along in the background having very little impact on them. This is not the case for factoring. The factoring company has a close and ongoing relationship with your business in that they are providing a collection service in respect of your outstanding sales invoices. This means that the factoring company also has interaction with your customers. For this reason, it is highly important to choose a company that can provide a professional yet effective credit control service that will suit your business.

  THE ANSWER: Once again, it is a case of looking around to find a factoring company whose style best suits your business rather than just choosing the cheapest quotation you can find. We can advise you about this.

  4.      Hidden Factoring Charges

  We often speak to prospective clients who are dissatisfied with their current factoring company because they feel that the company have levied all sorts of hidden charges, which have pushed up the cost.

  THE ANSWER: Before entering into a factoring agreement, you should ask the factoring company to provide a full statement of any additional charges that could be incurred so that you can be fully aware of the costs that you will incur for additional services if you require them. Once again, we can help you find the right pricing structure for you, even deals with no additional charges at all.

  5.      Leaving Things Too Late

  The stronger the position of your business, the better the deal will be that you can command from a factoring company. If you wait until your company is in dire straits, the factoring company will seek to charge a fee that they feel reflects the additional risk they are taking.

  THE ANSWER: If you plan and arrange your factoring agreement before you get into cash flow difficulties you will be in a much stronger negotiating position in respect of rates and terms.

  6.      Overstating Your Financial Projections  

  Another common problem that we have seen is that a business will come up with a set of financial projections that are beyond what they are likely to be able to achieve. Often they hope that this will secure them a cheaper deal with the factoring company. If they then arrange their factoring agreement based on these projections, whilst the factoring company may give them a beneficial rate, that reflects the high level of turnover that they are projecting, they may also implement minimum fees that also reflect the high level of turnover. If the business then fails to achieve the turnover that has been projected it may still incur the minimum fee which is then disproportionate to the volume of trade.

  THE ANSWER: The answer is simple, be realistic in the projections that you produce and on which the factoring agreement is costed and be clear about any minimums within your agreement.

  7.      Fresh Air Invoicing

  The term "fresh air invoicing" means raising an invoice that does not have any underlying trading transaction i.e. no goods or services were delivered. Sometimes, when a business gets into difficulty, they may seek to raise some fresh air invoices to receive additional funding from the factoring company. In many cases, the client company only intends to do this for a short period whilst they overcome a short-term problem, and in many cases, they fully intend to repay the factoring company, at some point in the future. However, once they breach the terms of the factoring agreement in this way it often becomes difficult to repay the funding that has been raised and the company gets into more and more trouble and they resort to raising more and more fresh air invoicing to maintain their cash flow.

  THE ANSWER: The answer is not to get into this situation in the first place. Many factoring companies will be sympathetic if they are approached for additional help when they encounter a cash flow problem. In many cases, the factoring company will be prepared to provide additional funding in the form of, for example, a short-term overpayment to see you through the problem.

  Summary

  Hopefully, being aware of the pitfalls of entering into a factoring agreement will help you avoid them by following the suggestions given above. Factoring continues to be a very effective way of funding a growing business that is used by a large number of companies within the UK.

  Final Thoughts and Recommendations

  Factoring agreements offer a viable solution for many UK-based companies facing cash flow challenges. However, like all financial tools, they require a thorough understanding and careful navigation. By staying informed, vetting potential factors, and aligning the agreement with business goals, companies can harness the benefits of factoring while mitigating potential risks.

  Conclusions

  Understanding your factoring agreement is more than just reading the fine print. It's about aligning it with your business's needs, goals, and future aspirations. As the UK market continues to evolve, so will the world of factoring. By staying informed and proactive, UK-based companies can ensure that their factoring agreements serve as a powerful tool for financial stability and growth.

  We hope this comprehensive guide has provided valuable insights for UK-based companies considering factoring as a financial solution.

  

  FAQ: Understanding Your Factoring Agreement

  Below are some frequently asked questions that we can answer for you.

  1. What is a factoring agreement?

  A factoring agreement is a contractual arrangement where a business sells its accounts receivable (invoices) to a third-party company, known as a factor, in exchange for immediate funds. Typically the agreement will be a printed, legally binding contract that both parties sign. The offer letter and other subsidiary documents may constitute part of the agreement.

  2. Can any business use factoring as a financial solution?

  While many businesses can benefit from factoring, it's especially popular among companies with long invoice payment terms or those experiencing rapid growth and needing immediate cash flow. Industries like manufacturing, wholesale, staffing, and transportation often use factoring. To qualify companies need to sell to other businesses on credit terms.

  3. How does the factor determine the advance rate and fees?

  The advance rate and fees are typically determined based on several factors, including the creditworthiness of the business's clients, the average invoice amount, the industry, the volume of turnover and the historical collection period. A business with clients who have a strong credit history might receive a higher advance rate and lower fees. 

  4. What happens if a client disputes an invoice that has been factored?

  If a client disputes an invoice, the resolution process will depend on the terms of the factoring agreement. In some cases, the business might need to resolve the dispute directly with the client. If the dispute is valid and the invoice is uncollectible, the business might be responsible for repaying the advanced amount to the factor, especially in recourse factoring.

  5. Are there alternatives to factoring for businesses needing quick cash flow?

  Yes, there are several alternatives to factoring. Some of these include:

  • Business Line of Credit: A revolving credit line that businesses can draw from as needed.
  • Invoice Discounting: Similar to factoring, but the business retains control over the collection process.
  • Merchant Cash Advances: A lump sum in exchange for a portion of future credit card sales.
  • Business Loans: Traditional loans provided by banking institutions or independent lenders.

  Each option has its pros and cons, and businesses should evaluate them based on their specific needs.

  6. Are there any hidden fees associated with factoring agreements?

  While the primary cost in a factoring agreement is the discount rate or factoring fee, there might be additional fees such as account setup fees, money transfer fees, or overdue fees. It's crucial to request a detailed breakdown of all costs and understand them before entering into an agreement.

  By Glenn Blackman