Invoice factoring companies don’t require their clients to pledge collateral other than their accounts receivable. Because of this, it is critical for the factor to feel extremely confident that they will be “paid back” by the customer of the client. Progress billings, which are typically present in construction relationships, are usually not compatible with accounts receivable factoring.
It is first important to understand the mechanics of factoring. Here are some of the most significant concepts to know:
- The client must produce goods or services that they sell to another business
- The customer must be credit worthy (they consistently pay in a timely manner)
- The receivables must be unencumbered. This means that no lending institution, government agency, company, or person can have a lien against the receivables. In order to establish a factoring arrangement, the lien must be extinguished so the factoring company can have a first position on the collateral
- Long term receivables or contracts cannot be factored. When an invoice is unpaid after 90 days, most factoring companies expect the client to replace that invoice with a new one
- The factoring company must be able to verify the invoice as being correct and that it will be paid by communicating with the customer
- Payments on the invoices must be paid to a lock box controlled by the factoring company
- The goods or services relating to the invoice must be complete
It is the last item that merits attention, especially with construction factoring or other situations in which payments on a contract are made throughout the term. Progress billing is present when there is typically a long term project with a final outcome. An example might be a contractor who is building a water tower for a city. Since the finished product won’t be completed for quite a while, the city allows the constractor to bill them in monthly installments. But there has not been a milestone.
In other words, even though the contractor is making progress on the project, the city won’t be satisfied until the water tower is totally finished. In this situation, factoring companies are leery of advancing funds on the billing. If for whatever reason, the contractor decided to walk away from the job, the city would consider the company to be in breach of contract and probably withhold payment.
On the other hand, if the project contained milestones, which represent the completion of parts of the contract, the client will probably be able to factor invoices. Let’s say the project involves constructing various statues in city parks. The city allows the contractor to bill them each time a statue is finished. This invoice would be “factorable” since a milestone has been set.
Although the issue of progress billings versus milestones are most commonly present in the construction industry, it can apply to other segments as well. Another example might be a marketing firm developing commercials for a major network. The firm bills the network on a periodic basis until the commercial is complete, Are these progress billings or have milestones been set?
These issues can oftentimes be settled by incorporating certain language in the contract that establishes milestones. Remember, the factoring company simply needs to have a comfort level that they will be paid by the debtor.
