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Factoring is fast becoming a very popular funding option for small businesses today. In factoring, you sell your invoice to a factor and in return you get a cash advance, which is typically about 80% the value of the invoice sold. When the customer pays in full, the factor then sends you the rest of the payment after deducting its fees. But sometimes a customer doesn’t pay at all, and that’s where recourse and non-recourse factoring comes in.
The Typical Factoring Agreement
Most of the time (79% of the time, according to a 2009 International Factoring Association survey), the factoring service you get is the recourse type. Part of the agreement states that after a given time (from 60 to 120 days), you are contractually obligated to buy back the invoice from the factor. To prevent or minimize this from happening, factors always investigate the credit history of your customers. But the factor will be paid its money, one way or another.
Since this type of factoring agreement offers the least risk to your funder, the fees involved are much lower compared to the fees involved in non-recourse factoring.
Clarifying the Meaning of “Non-Recourse”
At some point in history, factoring was essentially a sale of invoices and factors took all the risk. Factors accepted the loss when the customers didn’t pay, which is why credit investigation and payment collection are integral aspects of the services they provide.
Today, that’s no longer the case, but non-recourse factoring is still offered. But the definition of “non-recourse” may vary depending on the factor. It is very rare for a factor to define non-recourse as assuming the risk of nonpayment for whatever reason. It’s much more common to define it as not forcing you to buy back the invoice if the customer becomes unable to pay because of bankruptcy.
Drawbacks of Non-Recourse
Because there’s an additional level of risk for your factor for the non-recourse option, you’re obliged to pay higher fees for the factoring service. But that’s not all the disadvantages. The factor may also limit your sales only to well-established customers, yet require higher minimum volume commitments. And the factor may be much more intrusive in its payment collection methods.
And you also need to keep in mind that bankruptcy is hardly the most common reason for nonpayment. Your factor may demand recompense when your customer fails to pay due to financial difficulties, because they didn’t technically go bankrupt.
The customer may have also failed to pay because of a dispute with you regarding the terms of the agreement. For example, they may declare that the goods you delivered were not in the quality or quantity specified in the contract. They may claim that the goods sent them were damaged or not good enough. If that’s the case, then the factor reserves the right to demand that you buy back the invoice of that customer.
So when is non-recourse factoring appropriate? It can act as insurance for you when the vast majority of your business comes from a handful of large companies. Since non-payment from one customer can have a very damaging effect on your business, it may be better for you to transfer the risk to the factor.