From time to time a factoring client wishes to switch from one factoring vendor to another accounts receivable funding source. Since the current factor is owed money on the receivables, factoring fees and has a UCC1 filing the incoming finance company has to "buyout" the accounts receivables from the existing ar funding company. For an experienced factoring company this buyout / payoff process is a fairly structured and routine process.
As long as all three parties (the factoring client, the current factoring company and the new factoring company are willing to cooperate and the accounts are in good order the factoring buyout goes relatively smooth. This buyout process is tricky because the incoming factor must initially rely on the invoice verification work and the account management of the old factor. The factoring buyout process can also be tricky because the numbers change frequently during the process as invoices payments come in and new invoices are billed. Sometimes the current factoring company does not want to loose the account so they enforce the factoring agreement to the letter. This often means the client is responsible for minimum monthly and other factoring fees that make switching cost prohibitive. In those cases the small business factoring client is forced to come up with additional capital or the new factoring company will have to really over advance to get the deal done. The factoring company might also absorb some of the old factor's fees as an expense of booking the new business. Sometimes these buyouts can lead to conflict amongst the parties. The International Factoring Association has addressed this issue in point 6 of their code of ethics.
A factoring buyout is best understood by examining the agreement that is used to facilitate the transfer of a factoring client from one factor to another. This agreement is called a factoring buyout letter (also known as a factoring payoff letter). Usually it is a three party agreement and addresses several simple points of the buyout transaction. The points the a buyout letter covers are:
- The dollar amount the current factor needs to be bought out on a certain date. The date is important because it changes each day as invoice collections are made, new invoices are purchased and as fees accrue.
- What accounts receivable are being purchased from current factor. This is usually accomplished by including a current accounts receivable aging as of the buyout date with the letter.
- A provision for the release of the UCC1 financing statement either by the old funding company or by the new incoming factoring company.
- A provision for a debtor release letter from the old factor that releases the account debtor from the assignment to old factor and continuing to make payment to that factoring company. Once they receive this letter they are now free to honor the new assignment of account receivable to pay the new factoring company for the invoice.
- Direction as to of what and for how long the previous funder will do with invoice payments they continue to receive after the buyout is complete.
The points above generally cover most of the disputes that can arise during a factoring payoff as well as the practical mechanics of the buyout transaction.
There two main ar buyout scenarios that arise in the normal course of factoring invoices for small business. One is the overadvance situation. The other an under advance situation. The first arises when the new factoring company has to over-advance to get the buyout done. The under less common but still frequent situation is when the new factoring company has to underadvance or advance less than their contractual advance rate to do the buyout. Below covers an example of each in very simplified assumptions as to the status of the factoring client's account at the time of the buyout.
Example of an over-advance situation:
This example of a factoring buyout assumes the following: $50,000 of open invoices on old factors books for less than 30 days, pricing with current factoring company per the factoring contract is a 90% advance, 3% factoring fee for 30 days, no money held in the factoring client's reserve account, an additional fee due outgoing factor of $2,000, the new factoring contract advance is 80%.
Buyout calculation for the $50,000 of open invoices:
A. Amount old factor advanced to client (90% x $50,000): $45,000
B. Accrued factoring fees ($50,000 x 3%): 1,500
C. Additional fees due: 2,000
D. Amount held in client's reserve account: 0
Buyout figure: $48,500
The new incoming ar funder has to pay $48,500 for the $50,000 of open receivables. This puts them at an effective advance rate of 97% on the first advance! (($48,500/$50,000)*100) Generally if advance rates are similar there still will be an over advance because old factor always has to be paid accrued factoring fees.
Example of an under-advance situation:
This example of a factoring buyout assumes the following: $50,000 of open invoices on old factors books for less than 30 days, pricing with current factoring company per the factoring contract is a 80% advance, 3% factoring fee for 30 days, $3,000 held in the factoring client's reserve account, an additional fee due outgoing factor of $2,000, the new factoring contract advance is 90%.
Buyout calculation for the $50,000 of open invoices:
A. Amount old factor advanced to client (80% x $50,000): $40,000
B. Accrued factoring fees ($50,000 x 3%): 1,500
C. Additional fees due: 2,000
D. Less the amount held in client's reserve account -3,000
Buyout figure: $40,500
The new incoming ar funder has to pay $40,500 for the $50,000 of open receivables. This puts them at an effective advance rate of 81%(($40,500/$50,000)*100) on the first advance which is well under the 90% advance rate in the new factoring agreement! As you can see every buyout is different because it happens as a snapshot in time and is very dependent on the difference in contractual obligations between the new factoring agreement and the old factoring agreement.
Overall the switching between factoring companies and the buyout process can be complex but usually goes smoothly. It depends on a number of variables and the cooperation of the factoring client and the two factoring companies. For an experienced factoring company this buyout / payoff process is a routine process.