Timothy Nelligan was in a jam.
It was about a year ago and his engineering firm, Katahdin Environmental Corp., had been doing well, getting paid by the state and developers to clean up soil and groundwater polluted by old oil tanks.
But those payments were a long time coming and his bank had cut off his line of credit as it tightened lending requirements, leaving Nelligan wondering how he’d make payroll and cover his tax bill.
“I saw disaster,” he said. “The ends would not meet. I had the sales but cash flow was a problem.”
So Nelligan took out what amounted to a payday loan for his business. Fast A/R Funding in Calabasas paid up front for most of the value of Nelligan’s accounts receivables, tiding him over until his customers paid.
Fast A/R Funding is a factor, a type of commercial financier that has been little known outside of the apparel world but is now increasingly common in other industries. Factors in Los Angeles say they’ve seen a big increase in business over the past few years as stricter lending requirements have kept small-business owners such as Nelligan from getting traditional – and cheaper – bank financing.
“In 2008, banks really stopped lending to smaller and even middle-market companies,” said Barry Morganstern, managing partner of Tarkus Capital LLC, a Thousand Oaks firm that advises factors and helps them raise capital. “So companies have turned to factoring for their working capital needs.”
Downtown L.A.’s Hana Financial Inc., for instance, did nearly $2 billion in factoring deals last year, about 30 percent more than in 2010. And executives at the L.A. office of Rosenthal & Rosenthal Inc., a New York factor, say they’ve doubled their business here over the past three years.
The past several years have been boom times for factors and other nonbank commercial finance companies. Between 2007 and 2011, factors and nonbank financiers saw business grow 47 percent nationwide, according Sageworks Inc., a financial analysis firm in Raleigh, N.C.
“Factoring has emerged as a viable financing option in recent years, particularly for rapidly growing companies,” said Sageworks analyst Tim McPeak.
How it works
Factors buy a company’s receivables – bills owed by other businesses – or lend money and hold receivables as collateral, letting businesses get cash today for payments they are to get in the future. They also provide credit protection and other services. Factoring deals vary in form and cost, but generally work like this:
A clothing manufacturer sells $1,000 worth of shirts to a retailer, who agrees to pay for the goods in 30 days. The manufacturer sells that invoice to a factor for less than face value. A typical discount might be 2 percent, but they vary widely, from a quarter percent to 6 percent or more.
The factor, like the retailer, has 30 days to pay.
But because it now owns the invoice, the factor is responsible for collecting payment from the retailer. After 30 days, the factor owes the manufacturer the agreed-upon amount. With a 2 percent discount, that’s $980.
If the retailer goes bankrupt or otherwise doesn’t pay, the factor – not the manufacturer – takes the loss. Factors take that risk because, before buying an invoice, they check the credit of the business that will be paying the bill. Large factors might have credit files on 100,000 or more businesses, from big retailers to mom-and-pop storefronts.
In some cases, a factor only performs credit checks on the retailers that buy the goods, collects payments and take a percentage in return – a kind of outsourced credit and billing department. Using those services saves clients money by eliminating the need for some back-office staff and by keeping bad debt off their books.
When factors provide financing, it’s a bit more complicated. Typically, a factor can immediately pay the manufacturer up to 80 percent of the value of an invoice. Once the retailer has paid, the factor gives the client the rest of the money – minus interest.
Upon giving an advance, factors usually charge fees or interest that can range from 1 percent to 5 percent per month. Annualized, that’s between 12 percent and 60 percent.
“It’s not a cheap form of money,” said Katahdin’s Nelligan, who pays about 2 percent a month on advances. “But I exhausted my options and this is what I ended up executing.”
Largely because of those high fees, the factoring industry has a reputation for exploiting desperate business owners.
In one of the industry’s more salacious incidents, Los Angeles Police Department detectives in the mid-1990s linked an Orange County factor to the murders of several clients or former clients.
One victim, the owner of a recording studio, owed more than $1 million and was allegedly forced to take out a $2.5 million life insurance policy – payable to factor Coleman Allen. He was later shot to death, police believe, by a hit man Allen hired. At the time, LAPD detectives likened factoring to a legal form of loan-sharking. (Allen died soon thereafter of natural causes; no charges were ever filed against him.)
Edward Von Leffern, a management lecturer at Cal Poly Pomona and an adviser at the California Small Business Development Center in Long Beach, said he cautions businesses about using factoring.
“If one of my clients is offered factoring, I want to read the contract as there are many hidden items that are unacceptable,” Von Leffern said.
Michael Baum, an attorney with Resch Polster & Berger LLP in Hollywood who has represented factoring clients, said there are plenty of ways for factors to squeeze extra money out of a deal.
For instance, Baum said some deals allow a factor to continue charging a client interest even after their receivables have been paid. Instead of paying interest for 30 days, the client might pay 32 or 35 days.
“Often, clients don’t understand what their true cost is,” he said. “The first time I ever read a factoring contract, the thing might as well have been written in Chinese.”
But Baum and Von Leffern also said that if other kinds of financing aren’t available and a fair deal can be worked out, factoring can be a useful tool.
“Often it comes down to how well a small business can negotiate pricing and terms,” Von Leffern said.
A few banks including Wells Fargo and Carson’s Merchants Bank of California offer factoring, but generally factors serve clients that banks can’t – smaller businesses with fewer assets to borrow against.
“Not everyone can qualify for a bank loan,” said Wade Francis, president of bank consulting firm Unicon Financial Services Inc. in Long Beach. “They don’t qualify for unsecured lending and they don’t qualify for a mortgage on their building because most businesses are renting. Bottom line a lot of businesses could disappear pretty quick.”
Blaine Waugh, national sales manager for Redondo Beach factor Riviera Finance LLC, said he frequently confronts the notion that factoring is somehow unsavory.
“People will say, ‘Factoring is so expensive. I can’t believe businesses use you guys. It’s usury,’” he said. “All they see is the annualized cost. It’s frustrating.”
But he and other factors defend their rates, saying their fees cover the cost of checking customers’ credit, collecting and processing payments, and compensating them for taking on the risk that a customer won’t pay.
“Is it expensive? Damn right,” Waugh said. “We take a lot of risk.”
Sunnie S. Kim, chief executive of Hana Financial, said many of her clients sold clothes to department store Mervyn’s, which filed for liquidation in 2008. Without Hana or another factor, those clients would have either lost money or had to try to collect from Mervyn’s in bankruptcy court, which factors do in their stead.
“Several clients sold Mervyn’s receivables to Hana,” Kim said. “When Mervyn’s went bankrupt, we paid full money to our clients. Our lending price is higher, but we provide the credit protection.”
She and other factors also note that, unlike banks, which can raise capital for loans by accepting low- or no-interest deposits, factors typically have to pay for their money, either from private investors or in the form of bank loans. That means they have to charge higher rates if they want to have a margin for themselves.
Despite the cost, there’s plenty of demand. Factors Chain International, a factoring network in Amsterdam, the Netherlands, reports that about $105 billion in factoring deals were done in 2011, above the previous peak of $100 billion in 2008.
As major retailers struggle, factors that work in the apparel and manufacturing industries say they’ve seen more businesses interested in the credit protection they provide. Fashion firms want to make sure that if Sears Holding Corp., J.C. Penney Co. or smaller retailers go under, they don’t lose money or end up as creditors in a bankruptcy case.
“A couple of major retailers have begun to post challenging results,” said Kevin Sullivan, western regional manager for Wells Fargo Capital Finance, a unit of San Francisco’s Wells Fargo & Co. that offers factoring. “As that’s happened, we’ve seen companies gravitate toward that credit protection offering.”
He said Wells Fargo’s factoring volume has grown by about 50 percent nationwide over the past five years and should hit about $30 billion this year.
Still other factors have grown by reaching into new industries. A decade ago, nearly 90 percent of Hana’s business was in the apparel industry, but now it’s less than 70 percent, despite big growth for Hana. Kim said she now works with clients who make toys, electronics and auto parts, as well as temp agencies and other staffing businesses.
“The apparel and textile business is saturated already, but there are many businesses in need of credit protection on their receivables,” she said. “We have clients providing nurses to hospitals, clients who do cleaning for big hotels. Any business that has receivables can be a prospect.”
Fast Pay Partners LLC, a Beverly Hills factor founded in 2009, works exclusively in the digital media industry, providing funding to clients paid by corporate advertisers such as Atlanta’s Coca-Cola Co. and Cincinnati’s Procter & Gamble Co.
Riviera Finance has long provided factoring to trucking companies – another industry where factoring is common – but now does about half of its business with companies providing catering, private security and other services.
Waugh, Riviera’s national sales manager, said one of Riviera’s fastest growing markets is oil and gas. It’s an industry where factoring makes sense: Lots of small businesses, from water haulers to drillers to staffing agencies, get paid millions of dollars by giant oil companies that take a month a more to send checks.
“Most of the money comes from 10 or 15 giant players, and most pay in 60 days,” he said. “They’re not a problem in terms of credit, it’s just a matter of when they pay.”
Hana and other larger factors have also grown as they’ve taken customers away from New York’s CIT Group Inc. Once the nation’s largest factor, CIT has continued to lose billions in factoring business since its 2009 bankruptcy reorganization. The company got in trouble when it started diversifying from factoring and got into subprime mortgages.
The company’s factoring volume – the dollar value of its deals – fell from $45 billion in 2007 to $25 billion in 2012, a 44 percent drop.
“When they had problems, a lot of clients said, ‘We can’t rely on CIT,’ so they started going to places like Rosenthal and Hana,” said Anthony Callobre, a partner in the banking and finance practice of downtown L.A. law firm Buchalter Nemer. “A lot of growth has been at the expense of CIT.”
Hana’s Kim said she has picked up former CIT clients over the past few years, as did Sullivan at Wells Fargo.
Though their factoring volume has continued to drop, CIT executives say they have started to bring former customers back to the fold.
“The restructuring is three years behind us. From my perspective, it’s a rear-view mirror,” said Jon Lucas, president of CIT’s trade finance division. “We’ve been successful in bringing a lot of our business back.”
But even smaller factors, ones that don’t compete with CIT, have picked up business as the market for their services has expanded. Across the board, factors say they’ve been helped by the tighter bank-lending requirements that have made it more difficult for small businesses to get loans.
In June, banks headquartered in Los Angeles County had $1.16 billion in commercial and industrial loans of $250,000 or less on their books, according to the Federal Deposit Insurance Corp. That’s an improvement over the previous two years, but still down 29 percent from June 2007, when those loans topped $1.62 billion.
Sydnee Breuer, a senior vice president in the Woodland Hills office of Rosenthal & Rosenthal, said factors can work with businesses that banks shy away from.
“Banks want two to three years of profitability,” she said. “With the economy we’re coming through, show me a company that hasn’t had a loss in the last three years. In and of itself, two or three years of losses don’t scare us.”
All that opportunity is driving more companies into the factoring business. There are few regulations or barriers to entering the industry, and it might take as little as $1 million in capital from friends and family to start up a small factoring shop, said Tarkus’ Morganstern.
Morganstern was co-founder of the International Factoring Association, a Pismo Beach trade group. The association has grown its membership by between 5 percent and 10 percent annually in each of the past few years, said Bert Goldberg, the group’s executive director.
“There are a lot more people getting into factoring than there are leaving,” he said.
Factors and other commercial finance companies saw their profit margins grow from just over 9 percent in 2009 to more than 13 percent in 2011, according to Sageworks, but those numbers are likely on the way down as factors say they are charging lower rates and fees amid increased competition.
Factors that just a few years ago could charge annualized rates of 20 percent or 30 percent might be willing to settle for 14 percent today, said Bob Zadek, an attorney in the San Francisco office of Buchalter Nemer who specializes in factoring. That means it might be tougher for new factors to make a go of it.
“There are a gajillion lenders,” he said. “I help a factoring company get started every month. I start by trying to talk them out of it.”