Factoring & A/R Lending

What is factoring or account receivable financing?

Factoring or account receivables financing is a common financing product offered to small businesses to access short term financing. The small businesses may have short term needs to fund their business, expand their footprint or hire key personnel and these expected or unexpected growth opportunities need cash to finance their goals.

A small business owner has multiple ways to borrow money to fund their business. One of the ways is to use their own personal credit card to fund their business. Many small business owners are using their personal savings and credit to fund their business. 

Eventually, their personal savings or credit are exhausted and they need to seek funding elsewhere. Another way to fund their business without diluting equity is hard money lending. Hard money lending is akin to payday loans for small businesses. These forms of lending are unsecured and can be very expensive to repay.

Sometimes small businesses will continue to use hard money loans to fund their businesses and drive their businesses to the ground because any available revenue is used to repay outstanding debt and eventually they will have to declare bankruptcy.

Factoring or account receivable financing is a slight less expensive way of borrowing money to fund the day to day operations of a business. The reason why this form of financing is slightly cheaper is because the business is putting up their future revenue as a security against the outstanding debt.

In other words, these businesses are selling their future income at a discount today to get the money they need to grow.

How does factoring and account receivable financing work?

One of the ways for lenders to secure against the businesses future receivable is to have the business re-assign their future income to the lender directly. In essence the business client’s invoice is paid directly to the lender. 

The other way to secure future receivables is to process payments through the lender’s payment network. For example, if the business is a pizza restaurant and they process payments through a terminal at checkout. These payment terminals will get swapped out with the lender's payment terminal. When a patron swipes their credit card to pay for their pizza, the lender gets the payment first. The lender will take out whatever they need to repay their loan for that day and remit the remaining balance back to the business. Thereby secure their repayment for the loan they extended to the business.

In this way, the lender feels that the only way that they won’t get paid will be some catastrophic problem with the business. Either the business goes bankrupt or their service wasn’t rendered as promised and invoices aren’t paid.

There is another form of financing to help the business’s bottom line which is that the lender will pay for certain expenses directly on behalf of the business to lower their cash flow burden. Let’s say that the business relies on Google Adwords advertising to drive sales and they need to pay Google on a weekly or monthly basis, the lender will take over that payment and pay Google directly.

Perhaps the lender also specializes in Google Adwords campaign management and can help the business to optimize their spend and drive even more revenue and help them to grow to better the chance of the lender’s loan’s repayment.

Whatever the case might be, the small business owners have plenty of options to finance their growth without diluting the ownership of their business.

Equity financing vs debt financing, which is better?

A common way to fuel business growth is to raise equity capital. If you are operating a hyper growth startup that’s investable, venture capital and private equity are something a good option to finance your business.

The benefit of equity financing is that it is not a loan and therefore there’s no interest or repayment for the small business owner to worry about. These investors invest money into their business hoping for an exit when the business is sold to a larger business or becoming a publicly traded company in a few years.

The downside for business owners to take on equity investment is that they are essentially selling a part of their business today and diluting their ownership. Sometimes a business owner or the startup founder end up with nothing at a liquidation event because they have diluted themselves so much that any sale proceeds are essentially paid to their equity investors. 

Debt financing on the other hand doesn’t dilute the business owner but there’s an expected interest and principal payment made back to the lender at a predetermined interval. 

Who’s offering factoring and account receivable financing?

Typically these loans are not offered by the bank and are exclusively offered by private lenders with private money.

Private lenders can tolerate more risk than bank’s lender capital requirements. There is a vast network of private lenders and hard money lenders working with brokers to get businesses introduced and laying out a variety of loan options for these small businesses.

Big techs are also moving into small business lending. Companies such as Square and Amazon are getting into the lending business. These companies are uniquely positioned to understand the health of the business.

For example, Amazon finances retailers buying and selling on their platform. They have a real time insight into the small business’s financial health. The amount of order, the retailer's review, payments and refunds are all visible and available for Amazon to use to underwrite their small business clients.

Square, the b2b payments company is also uniquely positioned where they have visibility to their payments payment history. Square is using this information to offer different financial products to their clients. And Square can take what’s needed to repay their loan directly from the payments retailers receive through their Square payment network. In essence, Square gets their cut before the small business owners sees their money deposited into their account.

Any big tech that has an insight into small business’s supply chain or payment behavior are all vying to lend to these small businesses.

The US government also wants to lend to small businesses to spur economic growth. However the US government doesn’t lend directly to small businesses. They are leveraging the bank network to lend to businesses. The SBA or Small Business Administration has a variety of ways to help small businesses to grow, a loan for equipment or real estate are all within SBA’s wheelhouse. 

If your business is in the agriculture sector, USDA or United States Department of Agriculture offers loans to farmers and ranchers to get their business started or to help them expand their businesses.

Factoring and account receivable financing tech stack

Small business lenders must capture all aspects of the business’s information. There is plenty of fraud in SMB lending. The lender must verify that the business is in good standing, operating and generating revenue.

They also need to verify that the person applying for the loan on behalf of the business is authorized to apply for financing on behalf of the company. And that this person signing the repayment agreement is an authorized signer or a majority owner of the business.

When it comes to verifying controlling members of the business, lenders go to the distance to pull in expensive reports that verifies the true owner(s) of the business. If lenders grant a line of credit to a person that doesn’t own the business or a minority owner, the lender may not have recourse to go after the business and it might be very problematic for both parties involved. 

Income or revenue verification is a key for small businesses lenders to get right. If the lender is offering an unsecured loan, they must look at the company’s bank statement to make an inference in how much money this business is making over time and whether this business is bleeding money, break even or profitable. 

There are a variety of different electronic ways to verify the business’s income. The lender can ask the business owner to log into their business account through Plaid, Flinks and programmatically summarize credit and debits to formulate an idea of the health of the business.

If the lender is a lending against the businesses account receivable, there are a variety of technology offerings to let the lender log into the business’s account receivable system and summarize outstanding account receivables that will be paid in the next 30, 60, 90 days and make a risk based decision to lend against those future income.

Some lenders will ask for financial statements or tax filings from the previous year to make additional considerations when it comes to their lending decisions.

Lenders must have a robust LOS or loan origination system to take into consideration of collecting business related information. The decision should have the capability of running third party data providers such Lexis Nexis or CLEAR to verify the business. 

The LOS or decision engine must have the ability to collect all of the small business owners that represent the controlling percentage of the business, 51%. If there are multiple business owners collected through the application, the Decision Engine must be able to pull a credit report on all business owners.

The LOS and the decision engine must also have the ability to integrate into banking transaction history and account receivable platforms to summarize the historical credit and debit banking behavior as well as forecast the amount of income coming to the business within the next 30, 60, 90+ days. 

LendAPI LOS and Decision Engine

LendAPI’s LOS and decision engine can help you to get started. Our product builder can help you to build any type of application to collect any number of information from the business and its small business owners.
Give us a try at www.lendapi.com and sign up for our 30 days free trial at app.lendapi.com/signup