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Within the past two years, the economy has seen major turmoil and reduction of spending in well over a decade. The wellspring of venture capital dollars and commercial lending of the late 1990's has simply dried up, and cash flow has grown to a significant issue for most small to mid size businesses. As customers are demanding longer billing cycles, and suppliers are unwilling to extend the same, the small business owner tends to see their cash reserves dwindle. As a consequence, otherwise healthy businesses with strong long term revenue projections are faces with a dilemma of short term cash shortage.

One way to address this issue is through accounts receivable factoring. Originating from the New York garment industry during the early part of the 20th century, accounts receivable factoring has become an acceptable form of cash procurement in the business marketplace. Essentially, the transaction is structured so that the account receivable is treated like a transferable piece of personal property (the legal term in this case is chattel paper), which can bought and sold as a commodity. The sale element makes this transaction different from a loan, and therefore state usury laws would likely be inapplicable. Further, Article 9 of the Uniform Commercial Code generally governs these transactions, but each state has its different statutory nuances with respect to secured filings and the like.

There are two types of transactions, one being "Full-Recourse," the other "Non-Recourse." Full Recourse will require the business owner to buy back the account, "Non-Recourse" will not. In the event that the Seller's customer, the "account debtor," fails to pay, then the Seller bears the risk of buying back the account, paying back the Facto and still be responsible for the Factor's fees. Additionally, you can expect that a Seller may be asked to pledge personal collateral and sign a personal guarantee for payment. This collateral will tend to be subject to a secured filing form UCC-1 statement, basically giving the Factor priority over unsecured creditors if the Factor doesn't get paid.

The mechanics of the transaction are relatively simple. The Factor will buy a Seller's book (or portion thereof) of accounts receivables for a short period (usually 30-90 days), pay a purchase price (usually 65%-80%) of the face value and retain the remainder as a reserve. A portion of this payment is used to pay off the Seller's vendors upon delivery and possibly take advantage of early payment discounts that can offset some of the factoring costs; the remainder is left for the Seller's immediate use towards operations. When the account becomes due, the account debtor will pay the face value of the account receivable directly to the Factor. Upon receipt of payment, the Factor will deduct their fees and expenses and release the remaining amounts in reserve to the Seller.

Normally a Factor's fees run approximately 1%-3% of the face value of the account every ten (10) days the debt remains unpaid. If you start to add up a sixty day billing cycle, the fees can run as high as 18%. Although this is a rather exorbitant rate, like all competitive business marketplaces, everything is negotiable. Obviously, the more risk the Factor is incurring, the higher the rate. Nonetheless, small businesses should be encouraged to shop around to find a Factor with a reputation for delivery, excellent customer service, and the ability to work within your particular business needs. Additionally, factoring may not be the appropriate capital raising vehicle for every business, but it may buy some time as a temporary solution in this economic downturn where capital resources are not readily available.

David Michail is a business, corporate, entertainment and commercial transactions attorney for the Law Offices of David F. Michail, a Professional Corporation. This article is intended for informational purposes only, and shall not be construed as rendering legal advice. For further information on this issue, or to schedule Mr. Michail for public speaking engagements related to this or other business or entertainment law topics, please call 310-559-4333 or email Mr. Michail at david.michail@michaillaw.com.