A comprehensive guide to Factoring, AR Financing, and Third-Party Financing: How to find the right solution for your business.
As businesses grow and expand, one of the most critical challenges they face is managing cash flow and ensuring smooth operations. Factoring, accounts receivable (AR) financing, and third-party financing
As businesses grow and expand, one of the most critical challenges they face is managing cash flow and ensuring smooth operations. Factoring, accounts receivable (AR) financing, and third-party financing are all popular financial solutions that can help address this challenge. This blog will explore the key differences between these three options, focusing on costs, ease of deployment, scalability, customer experience, revenue recognition, and tax implications.
Factoring is a financial transaction in which a company sells its accounts receivables (invoices) to a third party, known as a factor. These factors are typically financial institutions or specialized finance companies who will take ownership of the outstanding debt and typically pay the vendor (selling company) 70-90% of the outstanding contract value. Factors will hold back some of the outstanding contract value as a reserve in case the debt does not get repaid. The factor then assumes the risk of collecting payments from the vendor’s customers and provides the company with immediate cash. Factoring typically comes at a higher cost than other financing options, due to the added risk assumed by the factor. There are a few key reasons why a company would choose to sell AR debt to a factoring company:
- Ease of deployment: Factoring is relatively easy to set up. Typically, a company interested in factoring needs to provide the factor with basic information about its business, including financial statements, customer invoices, and credit histories. Once the factor approves the company's application and determines the value of the invoices, the company can start selling its invoices to the factor. The factor typically sets up a dedicated account for the company, where the funds are deposited, and the company can access them immediately. While there may be some initial paperwork and due diligence involved, the factoring process is generally faster and more accessible than traditional bank loans or lines of credit, making it an attractive option for companies that need immediate access to working capital.
- Scalability: Factoring is scalable because it allows a company to access funding based on its current level of sales and accounts receivable. As the company grows and its sales increase, it can sell more invoices to the factor and obtain more funding. This means that factoring can be an effective financing option for companies of all sizes, from small businesses to large corporations, however, as a company grows, and volume of invoices increases, the costs of factoring will directly impact a companies bottom line.
- Customer experience: Once the debt is purchased, the factor will have direct contact with the customers AP team for payment collection, which does take the burden off the vendors AR team, but may not always align with the vendors preferred customer experience.
- Revenue recognition and tax implications: The revenue recognition and tax implications of factoring depend on whether the arrangement is a true sale or a financing arrangement. When the factoring arrangement is a true sale, then the revenue from the sale of the AR is recognized immediately, and the company can take an immediate tax deduction for any losses on the sale. The factor assumes the credit risk, and the company has no further obligation to the debtor. On the other hand, if the factoring arrangement is a financing arrangement, then the revenue is recognized over time as the payments are received from the debtor. The company cannot take an immediate tax deduction for any losses on the sale, but it can deduct any interest paid to the factor as an expense.
Accounts Receivable (AR) Financing:
AR financing, also known as invoice financing, is a loan provided by a bank or other financial institution, using a company's accounts receivable as collateral. When a vendor decides to apply for AR financing, they maintain control over their invoices and are responsible for collecting payments from their customers. Many companies will apply for loans backed by their accounts receivables to ensure their company can quickly increase internal cashflows, however AR financing can be expensive as it takes into account both the credit worthiness of a vendor and a buyer. When applying for AR financing, a business should consider:
- Ease of deployment: Deploying AR financing is a notoriously arduous process requiring rounds of legal revisions and a minimum AR threshold of $10,000,000 to gain interest from small banks. Larger banks have crafted a more straightforward approach, but will only work with businesses that have a strong accounts receivable balance ($50,00,000+) and great credit history. To begin the AR financing process, a vendor typically applies for financing with a lender, provides information on the outstanding invoices, and agrees to the terms of the financing agreement. Once approved, the lender may advance funds based on the value of the accounts receivable, typically up to 80-90% of the invoice value. However, the process may become more complex if the borrower has a low credit score or a high level of debt, as this may increase the lender's risk and lead to more stringent requirements or higher costs.
- Scalability: Scaling AR financing can be challenging for businesses as the amount of financing available is directly tied to the value of the accounts receivable balance. As the business grows and generates more invoices, accounts receivable may increase, allowing for more financing to be available. However, there may be limits to the amount of financing that can be obtained based on the lender's risk assessment and the creditworthiness of the business. Scaling AR financing requires careful management of the accounts receivable balance and ongoing evaluation of financing options to support the business's long-term financial needs.
- Customer experience: AR financing ensures a company retains control over its invoices and its collection process, ensuring a consistent customer experience.
- Default Risk: AR Financing facilities often feature early pay down and default triggers, which can put a company at material financial risk (e.g. risk of defaulting on the loan) if the vendor’s accounts receivable do not perform.
- Revenue recognition and tax implications: The revenue recognition and tax implications of AR financing depend on whether the arrangement is a sale or a financing arrangement. If the AR financing arrangement is a sale, then the revenue from the sale of the AR is recognized immediately, and the company can take an immediate tax deduction for any losses on the sale, thus the bank assumes the credit risk, and the company has no further obligation to the debtor. On the other hand, if the AR financing arrangement is a financing arrangement, then the revenue is recognized over time as the payments are received from the debtor. The company cannot take an immediate tax deduction for any losses on the financing, but it can deduct any interest paid to the bank as an expense.
3rd Party Financing:
Third-party financing involves a financing company providing capital directly to a vendors customers, enabling them to make purchases. Working with a 3rd party financier is typically the easiest and least risky way for a business to offer payment options to a buyer as they do not own the risk of the account receivable (common when a vendor opts to assume the AR on balance sheet), nor do they need to build custom sales processes to deploy payment options or manage payment collections (AR). Working with a 3rd party financing company can improve customer experience, promote buyer loyalty, and increase sales. When deciding to move forward with a 3rd party financing company you should consider:
- Costs: The cost of 3rd party financing is generally lower than factoring or AR financing as the cost of financing can be passed on to the buyer, making it an attractive option for businesses.
- Ease of deployment: Implementing 3rd party financing can be simple, with many providers having teams of lenders available to offer buyers financing in near real time. Today, Vartana offers a seamless integration with a company's existing CRM (Customer relationship management) system, making it easier than ever before to offer buyers custom financing options directly in the sales buying process.
- Scalability: 3rd party financing is highly scalable, as it can grow with the business and accommodate increased customer demand without burdening the company with additional debt. Companies large and small work with 3rd party financing companies to provide flexible payment options.
- Customer experience: With 3rd party financing, customers enjoy an enhanced experience, as they can access financing directly through the company. Typically a 3rd party financing provider will be connected directly with the buyer which can take the strain out of the payment closing motion, however on average partnering with a 3rd party slows down the sales cycle between 7-14 days. With Vartana, vendors have complete control of their financing options and leverage algorithms to ensure buyers are getting the best available rate, based on their credit worthiness, the size of the loan and the loan terms. By eliminating a new 3rd party from entering into discussions with a buyer, the sales rep is able to maintain full control of a deal and close it without any added time.
- Revenue recognition and tax implications: The revenue recognition and tax implications of third-party financing depend on various factors, including the specific product being sold, the terms of the sales agreement, and the applicable tax laws in the jurisdiction where the vendor and customer are located. However, there are some general principles to keep in mind. For starters, 3rd party financing is akin to having a vendor’s customer secure a loan from a bank to purchase a product on a “payment in full” basis, i.e. the buyer prepays for all goods and software purchases using proceeds from their loan. To that end, the vendor would treat the revenue and tax on that sale as if it were paid for in full upfront by any other means (e.g. by writing a check). Practically, from a revenue recognition perspective, this means that the vendor must recognize revenue when it is earned, meaning when the product has been delivered or the service has been performed, and the buyer is obligated to pay for it. A key benefit to financing with a 3rd party is that if the sales agreement includes any contingencies or warranties, revenue recognition may be delayed until those contingencies are resolved, and if the vendor is providing a subscription-based service, revenue should be recognized over the life of the subscription. As for tax implications, sales tax may be applicable on the transaction depending on the jurisdiction where the vendor and customer are located. The second is income tax which may be applicable on the revenue generated from the sale of the product, where the vendor will need to pay income tax on the profits earned from the sale, and depending on the jurisdiction, the vendor may be required to collect and remit sales tax to the appropriate taxing authorities.
Today, managing cash flow and ensuring smooth operations are critical challenges for growing businesses. To grow cash flow quickly and derisk a companies operations and accounts receivable, vendors often partake in a variety of financing practices. Factoring, accounts receivable financing, and third-party financing are financial solutions that can help address this challenge. Factoring involves selling accounts receivables to a third party, known as a factor, and typically comes at a higher cost due to the added risk assumed by the factor. AR financing is a loan provided by a bank or financial institution, using accounts receivable as collateral. It can be expensive, taking into account both the creditworthiness of a vendor and a buyer. Third-party financing is often the simplest option for a vendor as it is easy to deploy and results in the least risk for the vendor’s finance team. Deciding which financing option is best for your company can be difficult as all options have varying impacts on costs, scalability, ease of deployment, revenue recognition, tax implications, and customer experience. To learn more about Vartana and the way large enterprises are scaling their operations, visit vartana.com.