Reviewing Accounts Receivable Factoring Agreement: 9 Things to Check

Matthew Gillman | August 19, 2022


    Key Takeaways

    • Accounts receivable factoring agreements outline the terms, conditions, fees, and other details for the accounts receivable factoring. Business owners must review it before signing the document.

    • When reviewing your invoice factoring agreement, be sure to check for the name of both parties, advanced amount, invoice net term, commissions, type of factoring offered, approving credit checks, termination provisions, invoice default provisions, and non-payments responsibility. The terms and conditions reflected on the agreement should be more or less the same as the one you and the factor agreed to before the invoice factoring was approved.
    • Don't just skim through the agreement. Read the full agreement, know the requirements, and study how the factors interact with clients so that you'll know what to expect if you do decide to move forward with your application.

    One of the most important aspects of running a business is having enough capital to sustain the business operations. However, cash flow issues are bound to happen when customers fail to pay their invoices on time. For that reason, businesses often turn to accounts receivable or invoice factoring to bridge cash flow gaps.

    Once approved, the factor will draw a contract outlining the terms and conditions for the financing. As the other party in the financing, you have to make sure that you understand the agreement's fine print before signing it.

    However, just like reviewing other contracts, understanding invoice factoring agreements can be complex and daunting. This is true, especially if you don't understand some of the terms written in the agreement.

    In this guide, we've gone ahead and laid out the important things you should look at when reviewing your agreement. You must understand what each term means, so you will be well informed of what the financing entails going forward.

    What are Accounts Receivable Factoring Agreements?

    An accounts receivable factoring agreement is a legally binding document between the business owner and factor (company providing the invoice factoring services). The contract outlines the financing's terms, conditions, and the fees associated with the funding.

    Aside from that, the invoice factoring agreement may also contain the following:

    • Personal guarantee agreement
    • Secretary or Manager's Certificate
    • Proposed notice to your customers stating that their invoices have been assigned to a factor

    The factoring agreement is usually a few pages long and may be filled with legal jargon that some business owners might not understand. For that reason, it is always recommended to consult a business attorney specializing in small business financing when reviewing the accounts receivable factoring agreement.

    9 Things to Check in Every Factoring Agreement

    Suppose you've been approved of invoice factoring. The factoring company informs you of this good news and mentions that they will be sending the invoice financing agreement over. Once you receive the agreement, it's essential to go over the contract to ensure that it reflects the terms and conditions you and the lenders agreed to upon application. Failing to do so can result in serious consequences, and you could end up with a debt you can't afford to repay.

    When going over your accounts receivable factoring agreement, be sure to double-check the following things:

    1.  Name of Both Parties

    First off, the accounts receivable factoring agreement should clearly state which party is the factor and which one would be receiving the advanced amount. The factoring company's legal name should be written legibly on the agreement, along with the name of the business owner(s) or the authorized representative signing the agreement.

    Make sure that there are no typographical errors in the names. If you spot one, take note of the mistake and send the agreement back to the factoring company so that they can make the necessary corrections.

    2. Advanced Amount

    Factoring companies will buy the invoices from a company at a discount (usually 80% to 90% of the total value of the invoices factored). It should be clearly stated in the invoice factoring agreement how much you (the business) would receive upfront. The amount reflected on the agreement must be the same as what you and factor agreed to before approval.

    If they make some changes to the advanced amount or see some inconsistency, it's always wise to follow up with the factoring company and ask for an explanation.

    3. Invoice Net Terms

    Invoice net terms refer to the grace period before an invoice is due. Some factoring companies may require the invoices to have a net term of at least 45 days but should last no more than 90 days. Double-check the agreement to see if the invoices' net terms coincide with the factoring company's net term requirement.

    4. Commissions

    The commissions stated on the invoice factoring agreement refers to the percentage of the invoice value the factoring companies will charge as payment for their services. The charge is inclusive of the payment collection of the accounts receivables and credit protection. On top of that, the factor may charge the company with an additional surcharge if one of the business' clients is high-risk.

    The commission may be charged monthly, quarterly, semiannual, or annual, depending on what you and the lender have agreed to before approval. Be sure to check that in your factoring agreement as well.

    5. Type of Factoring Offered

    Depending on the factoring company you work with, they may require you to sell all of your accounts receivable ledger. Some companies would also allow you to choose the accounts you want to sell (called spot factoring).

    Before signing the agreement, be sure that the agreement clearly states the type of invoice factoring that the company offers. If you don't want to sell all of your company's outstanding invoices to the factors, working with a company that requires you to sell all of your invoices might not be the best route. On the other hand, if you choose spot factoring, the factor may require the invoices to reach a certain amount before they are qualified for factoring. The last thing you want is to work with a company that doesn't offer the type of invoice factoring that you actually need.

    6.  Approving Credit Checks

    If you're already familiar with invoice financing, then you know that the basis of approval for invoice factoring will be your customer's creditworthiness. With that, the factoring company should be allowed to run credit background checks on your customers so that they can gauge the risk they're facing by working with your company.

    The problem is, some customers might not be comfortable with the idea that a third-party company will be running a routine background check on them. In that case, you need to know what the alternative options are if there are any available. You'll want to know if the company will give you some time to negotiate with your clients. Regardless, the next steps should be outlined in the agreement.

    7. Termination Provisions

    Factoring companies may also set a rule regarding the length of the factoring relationship, and it should be stated in the invoice factoring agreement. Plus, if you decide to terminate the factoring relationship, this section should outline the steps that you need to take for the termination to be effective.

    Moreover, the agreement should also outline any fees associated with the termination of the factoring relationship. If there are fees, it should indicate how much, so you'll know what to expect.

    8. Invoice default provisions and fees

    There are also instances that one of the client's customers might fail to pay or delay their payments for the invoices. That said, you should check if the agreement mentions any default provisions. Some may consider late payments an honest mistake, but others may consider it a grave offense and take it as payment defaults. So be sure if the agreement states what a default constitutes.

    Furthermore, the factoring company may also charge an additional fee for every day that the invoices remain outstanding. So be sure to check carefully if there are any fees indicated in your agreement.

    9.  Nonpayment Responsibility  

    Invoice factoring can either be recourse or non-recourse factoring. In recourse factoring, the business will have to shoulder the unpaid customer invoices if the customer defaults. They can either replace it with another invoice of the same value or pay it using their cash reserves. In non-recourse factoring, the factoring company will shoulder all the losses if the customer fails to pay the outstanding invoices.

    Tips to Remember When Reviewing Your Invoice Factoring Agreement

    Reviewing any financial contract can be overwhelming, considering that a lot of legal and financial jargon is being thrown out there.  But it's vital to understand what the agreement entails and how it would impact your business now and in the future. That said, even if it's a daunting process, it's important to carefully go over the accounts receivable factoring agreement to avoid serious repercussions in the future.

    That said, while reviewing the agreement, be sure to keep these five tips in mind:

    1.  Read the Entire Contract

    While it can be tempting to just skim through it, fight the urge to do it. Financing companies may sometimes hide fees within the fine print of the contract.  By reviewing the entire thing, you'll be aware of the fees (if there are any) that they might charge to your account and avoid any costly surprises down the line.

    When reviewing the agreement, be sure to do it with a partner or someone who has extensive knowledge about business financing. This way, you can ask them of any terminologies that you might not understand.

    2. Understand the Requirements

    As mentioned, factoring companies may have a monthly minimum that you'll have to meet to qualify for their factoring services. Be sure that you know what the amount is, so you can supply it. Otherwise, the factoring company could penalize you and charge you for breaching the terms of the contract.

    More than that, be sure that you know which activities can lead to penalties. This way, you'll be fully aware of what to avoid mistakes that could cost you in the long run.

    3. Note how the factors interact with clients

    Once you sell your invoices to the factors, remember that the payment chasing and collection will become their responsibility. That means, they will be the ones that will interact with your clients, essentially making them an extension of your business.

    With that, you should know how the accounts receivable factoring company interacts with its clients. If you work with the factors directly, chances are, you will get a glimpse of their customer service. If you need some clarifications, ask them directly, and notice how they handle customer concerns.

    You want to maintain a good relationship with your customers, so they will keep coming back. So, it's essential to make sure that the factoring company will preserve your relationship with your customers. They should handle your customers as gently as possible so as not to lead to any disputes, which could taint your business' reputation.

    Final Thoughts

    Accounts receivable factoring is a helpful financial resource for companies that invoice their clients. It solves cash flow gaps that could otherwise be detrimental to the company if not addressed. However, before signing the accounts receivable factoring agreement, be sure to take the time to go over the document before signing. This way, you'll know what to expect from the financing - from the advanced amount to the fees associated with it - as you move forward with your application.

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