The biggest question when resorting to debt factoring is: what happens if the final customer, who place the order and received the goods or services, fails to pay for the invoice at all? The answer depends whether the factoring scheme is recourse factoring or non-recourse factoring. Simply said, the former option means the company will have to pay the bill back to the factor, and the latter that the factor will assume the loss. It gets a little bit more complicated when getting into details. Here’s what you need to know to make your choice between the two systems.
I) Recourse factoring: you remain liable for your client’s debt
Recourse factoring means that the company which issued the invoice and called in a factor to cover the payment remains ultimately liable to repay the factor in case the client, which was sent the invoice to, fails to pay. There are several ways the factoring client can repay this debt.
1) The principle
Although many factoring providers will have a slightly different definition of recourse, the main idea is that recourse covers what happens if nobody - factor or invoice issuing company - gets paid by the end-customer who ordered the goods or services - this end-customer is usually referred to as the “account debtor”- for whatever reason : financial problems, dispute about the order, or sheer dishonesty. Recourse factoring will in fact extend the quasi-loan to the invoice-issuer from anywhere between 45 and 180 days. After that period of time, the invoice-issuer will have to pay back the factor.
2) How it works
When an invoice is not paid during the agreed grace period, the factoring provider will proceed to “recourse”, which means, they will ask the company which delivered the goods, got the payment from the factor, to repurchase that invoice from the factor.
Practically, companies can repurchase the invoice in a variety of ways :
- they can provide the factor with yet another invoice, which the factor will use as collateral;
- they can opt to deduct the claimed amounts from the so-called reserve account held by the factor;
- or they can simply pay for the invoice themselves.
It is important to note that even though the invoice-issuing company will then remain responsible to collect the claimed amounts from the account debtor, factoring companies usually provide a debt-collection service to help these companies out - for yet another fee, of course.
II) Non-recourse factoring: the factor (may) be liable for your client’s debt
Non-recourse factoring means that the factor, not the invoice-issuing company, will be responsible for the contracted debt, in case the account debtor fails to pay. But there are stringent conditions for this system to work.
1) Simple definition
With this option, factors will purchase some or all of invoices and eventual related debts, should they not have been paid by the account debtor. As owners of these debts, they will find their own ways to collect the debt, or bear with the financial loss “without recourse” or charging back the unpaid invoice-issuer. Practically, the factoring provider acts like an insurer for the selected invoices. In theory, a non-recourse factoring contract means that if an account debtor does not pay an invoice, the factoring company will take the loss on that invoice, not the factoring client.
2) Fine print
As with any other insurance, interested parties should very carefully read the fine print, especially about what sources of payment default are covered - the non-recourse provision is usually very, very narrow. In fact, the majority of non-recourse factoring plans will only work when the account debtor files for bankruptcy or becomes insolvent, after the invoice has been issued.
3) Typical exclusions
Therefore, non-resource factoring plans will usually explicitly exclude most or all of the following default reasons:
- invoices offset by any matching debt owed by the seller to the account debtor;
- invoices sent directly by the client, instead of by the factor;
- invoices sent following any breach of contract with the factor caused by the client;
- invoices disputed for specified, or unspecified reasons;
- invoices claimed to a company where the interference of the client has made debt collection even worse.
III) Which option should be chosen?
Even beyond the issue of the narrowness of the cover, non-recourse factoring suffers from other disadvantages - and beyond its limitations, recourse factoring still has key advantages. Still, there are some cases when the former option may be preferred to the latter.
1) Disadvantages of non-recourse factoring
Besides the fact that the cover in this option is usually very narrow, the premium for this quasi-insurance is pretty high: clients should expect to pay anywhere between 40 and 80% more than for a regular recourse factoring agreement.
But... that’s only if they ever have the chance to be offered any deal at all. Since the risk is higher, factoring providers are extremely picky when selecting their clients for such a product.
Expect the application material and paperwork, both about the client and his own en-clients, to be much, much heavier than for other factoring contracts.
2) Advantages... and disadvantages of recourse factoring
In the light of this inconvenience, the other option seems more interesting. And it has its advantages, too. But one shouldn’t forget about its other disadvantages.
- The factor will offer lower rates, approve a more of your end-customers, and provide much, much more funding to support your business;
- Even if the client bears the ultimate brunt of the possible debt, the factor is there to help him perform free credit checks and analysis of his customers..
However, the client will need to maintain and fund a reserve account for the factor to tap in case the account debtor defaults. Small and medium companies may not have sufficient funds to feed such an account.
3) When non-recourse factoring still makes sense
The one situation where a non-recourse plan is still the better choice is when a large proportion of a company’s business comes from a small number of very big customers. The damage in case one of these customers defaults would be so devastating that any kind of debt insurance is welcome.
At the end of the day, companies and business owners interested in recourse and non-recourse factoring contracts should carefully review their financial needs, the solvency of their clients... and the fine print on the contracts proposed by the factors. They should be especially weary of sections related to “recourse”, “credit problem”, and “credit event”, to know exactly when the insurance will actually come into play. Even if recourse factoring still has massive advantages, it may not be for small companies either.