Accounts receivable are the amounts that customers owe to a business for the goods or services they have purchased on credit. For many businesses, accounts receivable are a significant asset that represents future cash inflows. However, waiting for customers to pay their invoices can create cash flow problems, especially if the payment terms are long or the customers are unreliable. To overcome this challenge, some businesses use a financing method called invoice factoring, which involves selling their accounts receivable to a third party at a discount.
Invoice factoring is a type of invoice finance where a business sells its outstanding invoices to a factor, which is a company that specializes in buying and collecting accounts receivable. The factor pays the business a percentage of the invoice value, usually between 70% and 90%, upfront. The factor then collects the full amount from the customer and pays the remaining balance to the business, minus a fee.
However, invoice factoring is not a simple transaction. It requires a legal agreement between the business and the factor, which is called an accounts receivable purchase agreement (ARPA). An ARPA is a contract that specifies the terms and conditions of the invoice factoring arrangement, such as the following:
- The amount and frequency of the invoices that the business can sell to the factor
- The percentage of the invoice value that the factor will advance to the business
- The fee that the factor will charge for its services, which may include a fixed fee, a variable fee based on the invoice amount or duration, or a combination of both
- The responsibility and liability for collecting the invoices from the customers, which may be shared or transferred from the business to the factor
- The recourse or non-recourse nature of the agreement, which determines whether the business or the factor bears the risk of non-payment or default by the customers
- The confidentiality or disclosure of the agreement to the customers, which affects whether the factor will contact the customers directly or through the business
- The duration and termination of the agreement, which defines how long the invoice factoring relationship will last and under what circumstances it can be ended
An ARPA is a legally binding document that protects the rights and interests of both parties. It also helps to prevent misunderstandings and disputes that may arise during the invoice factoring process.
Recourse or Non-Recourse Factoring
One of the key aspects of an ARPA is whether it is based on recourse or non-recourse factoring. Recourse factoring means that the business retains the risk of non-payment or default by the customers, and the factor has the right to assign the invoices back to the business if they are not paid within a certain period. Non-recourse factoring means that the factor assumes the risk of non-payment or default by the customers, and the business has no obligation to repay the factor if the invoices are not collected.
Recourse factoring is usually cheaper than non-recourse factoring, as the factor charges a lower fee for taking less risk. However, recourse factoring also exposes the business to the possibility of having to repay the factor if the customers fail to pay their invoices. This can create cash flow problems and affect the business’s credit rating. Therefore, recourse factoring is more suitable for businesses that have reliable and creditworthy customers, and that have sufficient cash reserves to deal with potential bad debts.
Non-recourse factoring is more expensive than recourse factoring, as the factor charges a higher fee for taking more risk. However, non-recourse factoring also provides the business with more certainty and protection against the risk of non-payment or default by the customers. This can improve the business’s cash flow and credit rating, and allow the business to focus on its core activities. Therefore, non-recourse factoring is more suitable for businesses that have uncertain or risky customers, and that want to avoid the hassle and cost of debt collection.
To implement recourse factoring with an ARPA, the business and the factor need to agree on the following terms:
- The invoices that are eligible for factoring, which may be subject to certain criteria such as minimum or maximum amounts, due dates, or credit ratings of the customers
- The recourse period, which is the time limit within which the factor can assign the invoices back to the business if they are not paid by the customers
- The recourse amount, which is the percentage of the invoice value that the business is liable to repay to the factor if the invoices are not collected
- The recourse fee, which is the additional fee that the factor charges for providing recourse factoring, which may be a fixed amount or a percentage of the invoice value or the recourse amount
- The recourse procedure, which is the process that the factor follows to notify the business of the unpaid invoices and to assign them back to the business
- To ensure that the recourse factoring is a true sale of the invoices, rather than a secured loan, the business and the factor need to comply with the following conditions:
- The business must transfer the legal title and the beneficial interest of the invoices to the factor, and the factor must have the right to enforce the invoices against the customers
- The business must not have the right to repurchase the invoices from the factor, except in the case of recourse
- The factor must not have the obligation to resell the invoices to the business, except in the case of recourse
- The factor must not account for any surplus or deficit from the collection of the invoices to the business, except in the case of recourse
- The business must not guarantee the payment of the invoices by the customers, except in the case of recourse
- The factor must not have any recourse to the business’s assets, except for the recourse amount
Invoice Discounting
Another type of invoice finance that businesses can use is invoice discounting, which is similar to factoring but with some key differences. Invoice discounting is a form of secured lending, where the business uses its invoices as collateral for a credit facility from a lender, rather than selling them to a factor. The lender pays the business a percentage of the invoice value, usually between 80% and 95%, upfront. The business then collects the full amount from the customer and pays the lender the remaining balance, plus interest and fees. Invoice discounting can also provide immediate cash flow for businesses, but with more control and flexibility over their sales ledger and customer relationships.
Invoice Discounting Agreements
However, invoice discounting also requires a legal agreement between the business and the lender, which is called an invoice discounting agreement (IDA). An IDA is a contract that specifies the terms and conditions of the invoice discounting arrangement, such as the following:
- The amount and frequency of the invoices that the business can use as collateral for the credit facility
- The percentage of the invoice value that the lender will advance to the business
- The interest rate and fees that the lender will charge for its services, which may include a service fee, a discount fee, a minimum fee, or a combination of these
- The responsibility and liability for collecting the invoices from the customers, which may be retained by the business or delegated to the lender
- The recourse or non-recourse nature of the agreement, which determines whether the business or the lender bears the risk of non-payment or default by the customers
- The confidentiality or disclosure of the agreement to the customers, which affects whether the lender will contact the customers directly or through the business
- The duration and termination of the agreement, which defines how long the invoice discounting relationship will last and under what circumstances it can be ended. An IDA is also a legally binding document that protects the rights and interests of both parties. It also helps to prevent misunderstandings and disputes that may arise during the invoice discounting process.
One of the key aspects of an IDA is whether it is based on recourse or non-recourse invoice discounting. Recourse invoice discounting means that the business retains the risk of non-payment or default by the customers, and the lender has the right to recover the advance from the business if the invoices are not paid within a certain period. Non-recourse invoice discounting means that the lender assumes the risk of non-payment or default by the customers, and the business has no obligation to repay the lender if the invoices are not collected.
Recourse vs Non-Recourse Invoice Discounting
Recourse invoice discounting is usually cheaper than non-recourse invoice discounting, as the lender charges a lower interest rate and fees for taking less risk. However, recourse invoice discounting also exposes the business to the possibility of having to repay the lender if the customers fail to pay their invoices. This can create cash flow problems and affect the business’s credit rating. Therefore, recourse invoice discounting is more suitable for businesses that have reliable and creditworthy customers, and that have sufficient cash reserves to deal with potential bad debts.
Non-recourse invoice discounting is more expensive than recourse invoice discounting, as the lender charges a higher interest rate and fees for taking more risk. However, non-recourse invoice discounting also provides the business with more certainty and protection against the risk of non-payment or default by the customers. This can improve the business’s cash flow and credit rating, and allow the business to focus on its core activities. Therefore, non-recourse invoice discounting is more suitable for businesses that have uncertain or risky customers, and that want to avoid the hassle and cost of debt collection.
Implementing Invoice Discounting with an IDA
To implement invoice discounting with an IDA, the business and the lender need to agree on the following terms:
- The invoices that are eligible for invoice discounting, which may be subject to certain criteria such as minimum or maximum amounts, due dates, or credit ratings of the customers
- The invoice discounting period, which is the time limit within which the lender can recover the advance from the business if the invoices are not paid by the customers
- The invoice discounting amount, which is the percentage of the invoice value that the business is liable to repay to the lender if the invoices are not collected
- The invoice discounting interest rate, which is the annual percentage rate that the lender charges for providing invoice discounting, which may be fixed or variable
- The invoice discounting fees, which are the additional fees that the lender charges for providing invoice discounting, which may include a service fee, a discount fee, a minimum fee, or a combination of these
- The invoice discounting procedure, which is the process that the lender follows to notify the business of the unpaid invoices and to recover the advance from the business
- To ensure that the invoice discounting is a valid and enforceable security interest over the invoices, rather than a sale or assignment, the business and the lender need to comply with the following conditions:
- The business must retain the legal title and the beneficial interest of the invoices, and the lender must have a charge or a lien over the invoices as collateral
- The business must have the right to collect the invoices from the customers, and the lender must have the right to step in and take over the collection if the business defaults or breaches the agreement
- The lender must not have the right to sell or assign the invoices to a third party, except in the case of enforcement
- The lender must account for any surplus or deficit from the collection of the invoices to the business, after deducting the invoice discounting amount, interest, and fees
- The business must not guarantee the payment of the invoices by the customers, except in the case of recourse
- The lender must have recourse to the business’s assets, up to the invoice discounting amount, if the invoices are not collected
In Conclusion
Invoice factoring and invoice discounting are two common forms of invoice finance that businesses can use to improve their cash flow and access working capital. However, they also involve different legal and financial implications, depending on the type and terms of the agreement. Therefore, businesses should carefully weigh the pros and cons of each option and review the contents and implications of the ARPA or the IDA before making a decision. Businesses should also consult with a professional adviser, such as a lawyer or an accountant, to ensure that the agreement is suitable for their needs and goals.
Here is a link to an example of a accounts receivable purchase agreement.
Here is a link to Barclays invoice discount agreement.
