The biggest question concerning debt factoring is what happens if a supplier’s customer, who placed the order and received the goods or services, fails to pay the supplier invoice. The answer depends on whether the factoring scheme is defined as "recourse" or "non-recourse” factoring.
The costs of using non-recourse factoring are higher due to the increased commercial risks of supplier invoice non-payment by the supplier's customers. Generally speaking:
- Recourse factoring means that the supplier will have to pay the value of the invoice to the factoring agent in the case of any non-payment of invoices by its customers. The factoring agent is purchasing the right to collect the value of the customer's invoices from the supplier but does not purchase the debt, as the liability for the debt is retained by and remains with the supplier.
- Non-recourse factoring means that the factoring agent will assume the loss of any invoices not paid by the supplier's customers. The factoring agent is purchasing the right to collect the value of the supplier's invoices and the debt. The liability for the non-payment of the customer's invoices transfers from the supplier to the factoring agent. Customer debts would be payable to the factoring agent rather than the supplier.
The factoring agent will charge more for the increased commercial risks of taking on the liability for the non-payment of invoices from the supplier. Hence, the factoring agent will want to analyse the commercial risk of the supplier’s customer base and may not be prepared in many cases to offer a non-recourse factoring agreement to smaller trading entities or trading entities that have a poor record of collecting debts from their customer base.
In these cases, the costs of a factoring agent may not make it worthwhile for a supplier to accept their invoice factoring services. With recourse factoring, the supplier remains liable for its customer's debts. The supplier that issued the invoice remains liable to repay the factoring agent when the supplier's customers fail to pay the supplier's invoices.
Although many factoring agents will have a slightly different recourse of action, the main thrust is that recourse covers what happens if the supplier's customers do not pay the factoring agent or supplier. The supplier's customers are usually called the "account debtor" in the event of the non-payment of the supplier invoices, which may be due to a customer's financial problems, a dispute about the order, or fraud.
Recourse factoring will extend the quasi-loan to the supplier from 45 to 180 days. After that period, the supplier will usually have to pay any monies back to the factoring agent for any financial resources gained against the supplier invoices that the supplier's customers did not pay.
When a supplier invoice is not paid during the agreed grace period, the factoring agent will proceed to "recourse", which means they will ask the supplier to repurchase that invoice back from the factoring agent. Suppliers can repurchase the invoice in a variety of ways:
- The
supplier can provide the factoring agent with another invoice to use as
collateral.
- The
supplier can deduct the unpaid invoice total from a "reserve
account" the factoring agent holds.
- The supplier may pay the invoice themselves.
It is important to note
that even though the supplier will remain responsible for collecting the
non-paid invoice amounts from its customer, the factoring agent will usually
provide a debt collection service to assist the supplier in managing unpaid
invoices for an additional charge.
In non-recourse factoring, the factoring agent may retain the liability for any unpaid customer invoice on behalf of the supplier, as non-recourse factoring means that the factoring agent, not the supplier, will be responsible for the contracted debt in the case of non-payment of the supplier invoices by its customers. However, there are stringent conditions for this system to work.
With non-recourse factoring, the factoring agent will purchase some or all of the supplier invoices and eventually related debts should the supplier's invoices not have been paid by the supplier's customers. As the owner of any unpaid invoice debts, the factoring agent will find ways to collect the indebtedness at minimum cost, or they will have to bear the economic loss "without recourse" or chargeback of the unpaid invoice to the supplier.
Practically, the factoring agents act like an insurer for the supplier's invoices as, in theory, a non-recourse factoring agreement means that if the supplier's customers fail to pay the supplier invoices, the factoring agent will take the loss on that invoice, not the supplier.
As with any business "insurance", suppliers should carefully read the fine print of a factoring agent agreement, especially about what sources of a payment default are covered, as the non-recourse provisions are usually very narrowly defined. Most non-recourse factoring agreements will only work when the supplier's customers file for bankruptcy or become insolvent after issuing the invoice.
Typical exclusions for a factoring agent non-recourse factoring agreement will usually explicitly exclude the following default reasons for the non-payment of the suppliers’ invoices:
- Supplier
invoices offset by any matching debt a customer owes to the supplier.
- Invoices
that are sent directly to a customer instead of the factoring agent.
- Invoices
that have been sent after any breach of agreement with the factoring
agent.
- Supplier
invoices disputed for specified or unspecified reasons.
- Supplier invoices claimed by a supplier where the supplier's actions dealing with the customer have reduced the chances of debt collection.
Non-recourse factoring has other disadvantages, but recourse factoring still has key advantages. There are some cases when non-recourse factoring may be preferred to recourse factoring. The burden of non-recourse factoring is that the cover the factoring agent provides is usually very narrow.
The costs for non-recourse factoring are high and will be anywhere between 40 and 80% more than for a regular recourse factoring agreement, assuming that the supplier is offered a non-recourse factoring agreement, as the risk for the factoring agent may be at levels that are unacceptable. Considering the higher costs of non-recourse factoring, recourse factoring has its advantages, such as:
- The
factoring agent will offer lower rates.
- Approve
an increased amount of the supplier's invoices for factoring.
- Provide
a higher degree of support for the supplier's business.
- The factoring agent may provide free or reduced-cost credit checks to assist in analysing the supplier's customer base.
However, it is essential to note that the supplier must maintain a reserve account for the factoring agent if its customers default on paying the supplier invoices. An SME may need more funds to support such an account.
Suppliers interested in utilising recourse and non-recourse factoring must be careful to read such agreements and ensure that they review their financial needs, as the solvency of the supplier may depend on the small print within the factoring agreement proposed by a factoring agent.
Suppliers should be especially weary of sections related to "recourse", "credit problem", and "credit event" to ensure that they know precisely when the factoring agreement will come into play. However, even if recourse factoring has massive advantages, the costs of using such services may not be worthwhile for small to medium-sized suppliers.
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