New Equity in Action Series: Mind the gap – Factoring proves to be a tricky financing solution for an urban planning firm

After nearly a year of pursuing bank financing options to help him maintain working capital, Keith Searles has earned the battle scars of a lifelong entrepreneur after only three years as chief executive and founder of Urban GIS, a Geographic Information Systems and urban planning solutions company.

In the long term, Searles said he would like for his Chicago-based company to be a self-financed, self-sustaining entity positioned for growth. But for the time being, he would be satisfied to find an accounts receivables financing, or factoring company, that will front cash for his public sector project invoices.

For Searles and countless other small business contractors who work primarily in the public sector, slow payments can – and often do — become one of the largest impediments to growth.In factoring, companies will front anywhere between 80 to 90 percent of the amount of the invoice. They get their money back once the invoice is paid and make money off the fees they assess businesses for the service.

Urban GIS provides mapping and GIS solutions for agencies responsible for managing public infrastructure. The firm’s clientele has been singularly focused on government entities with past clients including the Cook County Highway Department, the Illinois State Toll Highway Authority, the Metropolitan Water Reclamation District, the Federal Aviation Administration and the City of Country Club Hills.

While Searles’ is certain he will get paid by his government clients, payment often does not come in a timely manner. In fact, Searles said, in the current economic climate, there is no telling when those government checks will arrive. When the economy was good, payment usually was received within 30 days, he said. But in the past year, Searles said he has seen accounts receivables time grow to more than 90 days in some cases.

“They always pay,” Searles said of his government clients, “but they pay slowly.”

For Searles and countless other small business contractors who work primarily in the public sector, slow payments can – and often do — become one of the largest impediments to growth. Slow payment can also lead desperate entrepreneurs to resort to some of the most expensive forms of financing, factoring being one of them.

Factoring comes with its pros and cons, said Steven Rogers, the Gordon and Llura Gund Family Distinguished Professor of Entrepreneurship and professor of Entrepreneurial Finance at Northwestern University’s Kellogg School of Management. He is also director of the Larry and Carol Levy Institute for Entrepreneurial Practice.

The best thing about (factoring companies) is you have a relationship that says, if you provide a product, send me an invoice, and I’ll put 80 percent of the value of that money into your bank account within 24 hours.“The best thing about (factoring companies) is you have a relationship that says, if you provide a product, send me an invoice, and I’ll put 80 percent of the value of that money into your bank account within 24 hours,” Rogers said. “The negative about factoring it is very, very expensive. Factoring is three times as expensive as bank money.”

Rogers said that the interest rates on money loaned by factoring companies can range from 2 to 4 percent per month. “That’s a 24 percent annual interest compared to about 8 percent with a bank.”

Last November, Searles signed a yearlong contract with a factoring company he found through an independent sales consultant. He said that he has since learned that the factoring company prefers to work with Tier 1 consultants, or prime contractors, and has refused to purchase receivables for which Urban GIS is the Tier 2 consultant, or subcontractor, which is most of them.

“They haven’t shut me down; they’re just not doing enough for me,” said Searles, adding he increased his seasonal staff to 17 from 10 to accommodate his work load. “These are the projects for which I need working capital financing the most. The company didn’t make that clear in the contract that they did not want to deal with Tier 2 companies, and they knew I was a Tier 2 company. In my case, I’m not getting my needs met and I’m locked in.”

Rogers said that factoring companies are usually very explicit about the receivables they are willing to buy, as well as the type of companies and industries they are not willing to work with.

“I’m absolutely stunned that was the case, unless they had no knowledge of his industry,” Rogers said. “In fairness to this entrepreneur, sometimes what happens is factoring companies will learn more about industries after they’ve signed a relationship and decide they don’t want to do business with a company that does business in that industry.”

Searles has since learned some hard lessons in his quest for temporary financing by way of factoring. The first, he said, is to deal directly with the factoring company and not go through an independent salesperson.

“He gets a commission for every company he gets in there. It’s too his advantage to get me in and not tell me what I don’t want to hear. There is a conflict of interest.”

Searles recently hired a broker to help him identify a factoring company that does not carry the same stipulations as the one he is under contract with. However, he must weigh the cost of the potential penalty he might be charged on the money he has already borrowed in order to break the contract.

Searles’ first experience with factoring was a positive. He used accounts receivables financing that he received through Chicago Community Ventures to successfully start his business. “It worked well for a season. I got to a point where I was self-financed for close to a year.”

But soon after, the economy tanked and government payments became slower and slower, leaving Searles in the lurch. He has pursued other forms of financing such as a bank line of credit, but has been told his business isn’t old enough and that his debt ratios fall short.

Nonetheless, when it comes to factoring, entrepreneurs should beware of jumping into a factoring agreement with both feet without knowing where they will land…In Searles’ favor is the fact that he works primarily for government clients, Rogers said. Even though payments may be slow, the majority of factoring companies will be satisfied that they will eventually get paid by the government, Rogers said.

Nonetheless, when it comes to factoring, entrepreneurs should beware of jumping into a factoring agreement with both feet without knowing where they will land, especially when the factoring company requires a time commitment and levies early termination fees.

When considering financing by way of factoring, Rogers suggests business owners consider the following:

1. There are two types of factoring companies: Recourse Factoring and Non-Recourse Factoring. “The difference between the two is that the Recourse Factor has an agreement that says ‘If I don’t get paid, you owe me.’ The Non-Recourse Factor says ‘If I don’t get paid, I’ve taken that responsibility.’ Non-Recourse Factors will charge you a higher fee because they are taking a greater risk. The Non-Recourse factors are also less inclined to accept all your receivables. They will want to cherry pick. The Recourse Factor is cheaper. It depends on how much trust you have in your customers. Do you believe you have good customers and you want to use a factoring company simply as a means to get capital quicker? Or do you want to use a factoring company because you have questions about your customers?”
2. Factoring should be looked upon as a temporary fix, not a long-term solution: “The only reason it shouldn’t be temporary is when the entrepreneur has built the cost of that capital into the pricing to the customer,” Rogers said. “The company that does not build in the cost of factoring in their business will have long-term profitability problems.”
3. Choose a factoring company that has an affinity for doing business with companies like yours. “Look for people who know your industry. That is who you should be targeting.”

If your business is seeking or has recently secured small business financing and you would like your story to appear in our New Equity in Action Series, contact the New Equity Daily team at info@newequitydaily.com.