Recourse Factoring: What It Is & How It Works
Invoice factoring is increasing in popularity among small and medium-sized business owners. They come with numerous benefits. Invoice factoring as a finance option leaves several business owners confused about the kind of arrangement to pursue. Recourse factoring is by far the most popular type of invoice factoring since it can immediately increase your cash flow among other benefits.
Factoring may be a great way for businesses to get additional capital, but you need to know what you are getting into. This detailed guide will help you understand what recourse factoring is, how it works, pros and cons, and how it fairs against non-recourse factoring.
Understanding Recourse Factoring
Recourse factoring allows businesses to sell their customer’s invoice and free up considerable resources and time spent on collections in the short run. However, this invoice factoring method comes with recourse. The business selling the invoices retains all liability and risk if their customers fail to make good on the payment they owe. In such a situation, the business or seller will essentially have to repurchase the bad receivables sold to a factor if collections can’t be made by the lender.
This means that a factoring advance in recourse factoring is essentially a short term debt. One of the major concerns that small and medium sized businesses have over recourse factoring is that they may be held liable in the near future to repay particular invoices if their customers or debtor fails to pay them. If an invoice doesn’t get paid within a set period, you shall be held liable for making the payment to the factoring company.
How Does Recourse Factoring Work?
The funding partner, factor, or lender purchases your unpaid invoices from you in recourse factoring. However, this is done with the agreement that you will have to buy back the invoices if the customer fails, is unwilling, or unable to make the payments when they become due. Recourse factoring allows you to share the risk of a customer not paying their invoice with a funding partner.
When you factor your invoices with a lender, you would typically be paid in two installments. The first payment, also called the advance, is generally 80 – 90% of the total invoice value. The second payment will consist of all remaining balance minus the service fee of the factor. The business shall receive these payments when the factoring company is able to collect the invoice.
A typical recourse factoring agreement shall specify the maximum number of days a business can keep the advance payment in the event a receivable remains unpaid even after its maturity date. If your debtors or customers fail to remit the payment for invoices within a stipulated time, you will be required to return the advance amount to the factor. Depending on the agreement, you may also be required to replace any amount lost by offering another invoice.
Recourse factoring is gaining immense popularity because of a major advantage – you share the risk of non-payments with the factor. This allows factors to offer a larger upfront sum as advance against the invoices. Typically, your funding partner will offer anywhere from 80% to 90% of the invoice after taking a cut for their initial fee depending upon the agreement.
You will receive the reserve payment or remaining payment once the lending partner receives the full payment for the invoice from your customer.
An Example to better understand the working of recourse factoring:
Let’s say you have an invoice for $100 that is not yet due. You factor it with an agreement of 85% prepayment. You could raise $85 on the same day against your non-due and unpaid invoice with the right funding partner. This is similar to having your invoice partly paid immediately. You can use the payment of $85 for purchasing raw materials, paying off suppliers, and on other things to scale your business. (Factoring fee has been ignored for the sake of simplicity.)
You should get the remaining $15 whenever the customer makes their payment in full to the funding partner. However, if the customer fails to make the payment, for whatever reasons, your invoice will recourse or exceed the recourse period. You will have to return the advance payment of $85 or else you shall be considered overdrawn.
Advantages of Recourse Factoring
Recourse factoring has most benefits of invoice factoring in general. It is cheaper than traditional lines of credit and makes it easier for small businesses to get their hands on immediate cash. Recourse factoring also helps you delegate collection of receivables, to a major extent. This allows you to focus on your business operations. In addition, recourse factoring offers lower factoring rates and higher advance payments as opposed to non-recourse factoring options.
These are the benefits in a nutshell:
- Affordable factoring costs
- Higher advance payments
- Faster approvals
- Most funding partners carry out credit checks on invoice clients to minimize default risks
Cons of Recourse Factoring
Recourse factoring is not without its disadvantages to invoice sellers. Typically, these are the usual factoring drawbacks. For starters, advance rates offered may be low depending on the funding partner you work with. The factoring partner may insist on contacting your customers to make collections on past due invoices. This could cause you to lose customers.
Other downsides you should be aware of are:
- Payments in case of default needs to be paid immediately
- You may risk having your bank and income accounts garnished in case you cannot pay the default payment
Credit checks in recourse factoring are less stringent since you are essentially bearing the burden of risk and the factor has recourse for seeking any default payments. Some experts claim that recourse factoring can prove to be costly in the long run. However, it is still one of the best ways for a small business owner to finance growth and borrow large sums.
How is Recourse Factoring Different from Non-recourse Factoring?
The seller in recourse factoring is required to purchase all invoices that are unpaid even after the due date. In contrast, the factor company offering non-recourse factoring is required to absorb all risks and liabilities if the invoice client fails to make the payment, leaving the invoice seller unaffected. This is why non-recourse options are also called bad debt protection.
Businesses that can afford to lose a higher margin of their invoices and can make do with smaller upfront payments should take up non-recourse factoring options. The factoring company has to issue a new credit limit with every new customer or invoice. You will not be affected by recourse if a customer decides to default on their bills. You will be protected from any invoice client filing for bankruptcy and not paying the bills.
However, that doesn’t mean that non-recourse factoring options don’t come at a cost. Factoring partners tend to charge a higher fee that includes CPE or “credit protection element”. You may also suffer from receiving smaller availability amounts. Recourse factoring could be the best option if you deal with the same stream of customers and know that they will not default on their bills.
Businesses That May Benefit From Recourse Factoring
Recourse factoring is unlike non-recourse factoring that is more expensive to businesses and involves a higher risk to the lending partner. This type of invoice factoring can be ideal for you in the following situations:
- You have creditworthy clients
- You do not want to pay higher factoring fees
- You want to sell the client invoices at the lowest possible discount
- You want to receive higher advance amount for your customer bills
- You have the means to pay back the advance amount in case of a default
- You have other invoices of a higher amount that can be exchanged if there is a default
Non-recourse factoring may protect a business from paying back on defaulted bills. However, they also tend to cost more. You may end up receiving far less money than what you are due. This could affect your business operations, especially if you miscalculated the amount of discount you could absorb. Recourse factoring may be the option you want if you want to get the most cash for your invoices and are ready to bear the risk of a few clients defaulting.
Working with a Funding Partner for Recourse Factoring
You should start by learning the types of invoice factoring options offered by the funding partner. It is important that you pay special care to lending terms. It is best to do business with a lender that has an experienced team with a proven track record. If the agreement allows the factoring partner to make default collections on your behalf, it is important that you pay attention to their back office teams.
Lenders with excellent back end teams can identify customers that are more likely to pay the entire invoice amount upfront. They can also spot the clients that may not pay on time. Going after these clients can reduce the risk of non-payments in the future and mitigate your risk. Working with a high quality factor should be an important consideration when looking for additional capital.