Getting to Grips with the Terms and Conditions of a Factoring Agreement

What is a Factoring Agreement?

In its most basic form, a factoring agreement is a financial contract between a lender and a business whereby the lender purchases the accounts receivable of the business and loans the proceeds to that business. Specifically, such an agreement will provide that the lender will purchase or otherwise lend funds in an amount not less than a percent of the total accounts receivable submitted on a periodic basis (typically monthly) and, in some circumstances, will loan the business the entire amount of the receivable minus a discount or service fee . In exchange, the business agrees to pay the lender interest on the funds advanced at a specified rate of interest (again, typically monthly).
There are various types of factoring agreements of varying complexity, but the basic principal is the same – a business sells the right to its accounts receivable to a lender in exchange for an immediate influx of cash. Most businesses use factoring services because they need immediate payment and have few available alternative financing options. The downside to such agreements is that the fees charged are often higher than that for traditional bank loans and the business loses the right to collect on its receivables.

Common Terms in a Factoring Agreement

The following are common terms in a factoring agreement. A factor is a financial intermediary. The factor company or bank is an important party in the transaction and therefore its relationship with the business and how it is governed by the agreement is very important:
Term. The term of the contract may range from months to years. The length of term should be considered in relation to the business’ projected cash flow needs.
Basic rates. Basic rates come in two forms. The first is the discount rate, which is the rate paid to the factor when it collects money from a business’ client. The second form is the basic fee charged by the factor to the business. The fee is charged on each transaction financed. Variations of these rates include: monthly fees, a one-time upfront fee, or a one-time buying fee.
Advance. The advance is the amount of cash the factor provides the business in exchange for a certain portion of the unpaid invoices (often, invoices are paid in full). Often, a percentage of the invoice amount is withheld by the bank or company whenever it provides an advance to the business.
Reserve. The reserve is an amount held back from the business until the factor receives payment from the business’ client. After the factor collects payment on an invoice, it pays the business an amount equal to the reserve (less fees).
Purchase and Sale. The transaction between the business and factor is one of buying or advancing money to the business in exchange for its accounts receivables. The factor has the right to sell those accounts to investors at a markup. The reserve may be held in the account until the factor sells the accounts to investors.
Termination and Repurchase. At the end of the contract, the factor may terminate the agreement and request repayment from the business.
With recently enacted state legislation aimed at predatory lending, it will be interesting to see whether for factors, terms such as the term or rates become integrated into state usury analyses.

Conditions and Obligations

Typical conditions and obligations imposed on the parties to a factoring agreement include: complying with all laws, rules and regulations applicable in the jurisdiction of incorporation of the client, the jurisdiction where the account debtors are located and any other strategic jurisdiction where a claim may arise; the quality and location of records and maintenance of policies and procedures for compliance; obligation of the factoring company to verify within a specific period of time that the purchase order is accurate and the goods were delivered; satisfaction with respect to the timing and quality of delivered goods; satisfaction with respect to the quality and specific services performed; the obligations to purchase goods or products from the factoring company at the price set forth in the agreement.

Types of Factoring

There are two basic types of factoring arrangements, recourse and non-recourse factoring. In a recourse factoring agreement, the company that sells its receivables to the factor remains liable if the customers do not pay. A non-recourse factoring arrangement is where the factor receives a guarantee of payment, meaning if the customer does not pay, the factor can look to the company to make good on its guarantee. While oftentimes the term non-recourse is used, this is somewhat of a misnomer as even in a non-recourse factoring arrangement, the company must make good on its guarantee to pay the factor. In most cases, the company will have thirty days to resolve the situation before the factor seeks to enforce its right to guarantee.
The wholesale industry, where the dealer pays the company for the goods in advance, is a fairly typical use of a non-recourse factoring arrangement. Other clients prefer the security of guaranteed payment and take the extra step to establish a recourse factoring relationship with their factor. More usually, the terms of the factoring agreement may provide for recourse to the company, but only in certain circumstances such as, among others, when the factor is unable to establish creditworthiness of the customer or in the event of bankruptcy.

Risks and Protections Associated with a Factoring Agreement

Parting with money before it passes through one’s fingers is risky business for each of the parties to a factoring agreement: the seller who takes the money and the lender who gives it. The seller, in particular, may risk having its customer well informed of the transaction and motivated to find a cheaper or more favorable rate. At that point the lender may find its security interest subordinate to a lien from a subsequent lender.
To mitigate these risks, often each party will find legal protections built into the deal either by agreement among the parties or by operation of law. The security interest that the lender obtains is the most fundamental protection and upon attachment and perfection will trump subsequent liens provided those subsequent lien holders do not have prior perfected security interests .
Another protection commonly found in factoring agreements is the existence of a recourse period. The seller guarantees performance by its customer for some period of time. Within that time period, the lender can demand that the seller take back its goods and give back its money if its customer fails to pay on time. Understanding the recourse period is a critical part of analyzing a factoring agreement.
An additional area of protection, as discussed in the article, is the exclusion of certain types of sales that may be less creditworthy or difficult to administer. The exclusion won’t eliminate the risk of selling to these customers but will exclude them from affecting the factoring lender and will encourage the seller to move more quickly on finding another lending source.

Making a Good Deal

While a factoring agreement is a relatively simple contract, the parties will typically spend significant time negotiating its terms. The goal in these negotiations is to reach the right balance, or what has been termed a "win-win" for both parties.
To achieve this goal, it is best if the parties have very clear and realistic expectations at the outset. The business should review the various "uniform" industry formats for factoring agreements in order to identify those factors that are typically subject to negotiation.
Additionally, the business should understand from the outset that the factoring company will be restricting its collections to those accounts receivable that are deemed to be of low risk. The factoring company will not factor high risk invoices until it has reviewed them, typically after the fact.
A factoring company’s basic business model is to factor low risk accounts receivable to investors, for a fee. Part of what the business must do is to evidence to the factoring company that the business is a stable and low risk enterprise and to provide a detailed plan for reducing high risk accounts receivable.
The factoring company will likely be willing to negotiate various terms. Here are some examples of the types of items the business should consider negotiating:
This is not intended to be an exhaustive list as there may be additional items depending on the specific business, its needs and its future plans. This also is not a negotiation guide but should be used as a checklist for initial drafting of the agreement and to prepare for final negotiations.
It is critical to obtain thorough legal advice early in the negotiation process. Failure to do so can have detrimental consequences for the business.
An experienced business attorney will be able to assist the business in understanding the issues and risks presented in the factoring agreement. Furthermore, an attorney will be able to identify the areas that can be negotiated; or those that a business should strongly consider not changing.
Factoring agreement negotiations can be very difficult to step away from and the business will end up "lawyering up" in order to protect itself. While this may be true, it is better to interview several attorneys before entering into a factoring agreement (for guidance in vetting an attorney see our article Choosing the Right Attorney).
Finally, it is very important that the business fully understand the factoring agreement before it signs. There should be no ambiguity in the business’ mind as to what its obligations are under the agreement. Keep in mind that the factoring company will likely be changing and revising the agreement until the very end of the process.

Legal Aspects for Businesses

An important step when factoring receivables is carefully reviewing and understanding the provisions of the factoring agreement, which terms can be more or less harmful to a business. There are a number of factors to take into consideration when entering into a factoring relationship, and several laws and regulations that can apply to the transaction.
Among other things, businesses should look for the following when negotiating these agreements: indemnification provisions can be far-reaching, and it is important to ensure that general indemnification claims are limited to claims that relate to bad debt and not a business’s operations. It is not uncommon for the resulting indemnification obligation to not be subject to any cap. Also, important to a business’s bottom line, any indemnification obligation by the business to a factor arising out of certain events should not be transferable to the business’s customers. Confidentiality obligations in factoring agreements have become more typical, but a business should carefully review these clauses and ask for specific carve-outs for information that the business reasonably would need to share with its vendors or customers, or use in marketing materials. Termination rights in a factoring agreement should be negotiated carefully so that a business does not find itself unexpectedly without a source of working capital.
Many factoring agreements require businesses to deliver certain informational statements regarding their receivables to factors periodically; default or termination due to non-compliance with this requirement is a common event of default. Many factoring agreements also include exclusivity provisions that can prevent a business from doing business with other factors; it is important for a business to understand how important outside financing may be to its operations, before agreeing to an exclusivity provision. Are there exceptions to exclusivity? Do the provisions require delivery to the factor of information that may be essential to third parties who may have an interest in the business or its operations?
Another important consideration is the assignment of the business’s contracts to the factor, either through an assignment of receivables or a covenant obligating the business to assign to the factor any contract with its customer. In addition to common law contractual defenses, such as unconscionability, fraud, lack of capacity, mutual mistake and impracticability of performance, a business should be aware of the potential applicability of the Uniform Commercial Code (the "UCC"), particularly the provisions of the UCC which address the transfer of rights governed by Article 9; as well as the Federal Trade Commission’s ("FTC") rule regarding the granting of security interest in goods which may be purchased by the borrowers (the "FTC Rule").

The Bottom Line: How to Decide

As a startup business grows, every aspect of that business should be carefully considered, even the financing. As such, every term and condition of a factoring agreement should be understood. Without this knowledge, a business could be stuck in a situation where its cash flow is negatively impacted. Therefore , doing research is imperative. Seeking help from an expert in the field can also benefit a business. However, when looking for legal assistance, it is important to remain clear and concise in what is needed. That being said, an attorney can look for any hidden traps within the contract. Making an informed decision is crucial for every business.