Factoring vs asset-based lending: selling your invoices or borrowing against them

Selling invoices vs borrowing against them

In factoring, the business sells invoices. The factor pays an advance on each invoice it buys, holds back the remainder as a reserve, and when the customer pays, releases the reserve less its fee. The fee is usually a discount charged by time, so the longer a customer takes to pay, the more the invoice costs. The factor now owns the receivable, and it usually sends a notice of assignment telling the customer to pay the factor directly.

In asset-based lending, the business borrows. The lender takes a first lien on receivables, and often inventory, and makes a revolving line available up to a borrowing base: eligible receivables times an advance rate, plus eligible inventory times a lower one, less reserves. Asset-based lenders typically advance 80% to 90% of eligible receivables. The business keeps its receivables, its customers keep paying it, and the cash is swept to the lender to pay down the line. See how a borrowing base works.

That legal difference drives every practical one. A factor buying an invoice cares most whether the customer will pay it. An asset-based lender cares about that too, but it is also lending to the business, so it wants to understand the business's earnings, balance sheet and reporting.

Side by side

What each costs, and why

Factoring usually costs more than an asset-based line, and most of the difference is the work. The factor does more of the work: it checks customer credit, verifies invoices, runs collections and, without recourse, takes some credit risk. It also typically deals with smaller, younger businesses whose own statements it cannot rely on. And because the fee runs by time outstanding, a business whose customers pay slowly pays much more than the headline rate suggests. Compare factoring quotes on what an invoice costs at your customers' real payment speed, not at the fastest bracket.

An asset-based lender charges interest on what is drawn, plus fees for the commitment, field exams and monitoring. The rate is lower because the lender relies on the borrower's reporting instead of handling each invoice, has the whole business behind the loan, and is usually lending to a larger, more established company. The trade is the reporting burden and the lender's close watch over the collateral.

Factoring prices the work and the risk the factor takes on. ABL prices a loan to a business the lender can underwrite. The more of that work your own books can do, the more ABL makes sense.

Control, notification and recourse

Notification. Most factoring is notification factoring: customers receive a letter redirecting payment. For many businesses this is harmless; in some industries it is routine. For others it signals financial strain to customers or competitors. Non-notification factoring exists but is less common and priced accordingly. In ABL, customers normally pay into a lockbox or deposit account under the lender's control, and they need not know a lender is involved.

Control of cash. An asset-based lender usually takes some form of cash dominion: collections are swept daily to repay the line, and the business re-borrows what it needs. Many lenders use springing dominion, which applies only if availability drops below a threshold or a default occurs. The effect is that the lender always knows where the cash is, which is part of why it can lend more cheaply.

Recourse. Recourse factoring leaves the credit risk with the business: an invoice unpaid after an agreed period is charged back. Non-recourse factoring shifts some risk to the factor, but read the definition. It usually covers a customer's insolvency, not a customer who refuses to pay because of a dispute over the goods. An asset-based loan is always full recourse; unpaid receivables simply leave the borrowing base and reduce availability.

Eligibility. Both look at the same features of an invoice: age, customer concentration, disputes, customers who are also suppliers, related parties, government and foreign accounts. In a borrowing base, receivables more than 90 days past invoice are typically ineligible, and any single customer is commonly capped at 20% to 25% of eligible receivables. A factor may accept a heavier concentration if the concentrated customer is strong. See eligible vs ineligible receivables.

When a business graduates from factoring to ABL

Factoring is often the right start. It is available to businesses with thin equity, short histories or losses, because it leans on customer credit. The time to look at ABL is when the business has outgrown the reasons it factored. Asset-based lenders look for:

• Reliable monthly financials, closed on time, with a balance sheet that ties to the agings.
• Clean receivables: an aging by customer with days outstanding, low dilution from credits and returns, few disputes.
• Enough scale that the lender's cost of monitoring makes sense against the size of the line.
• Earnings, or a clear path to them. An ABL lender will lend through a soft patch, but it wants to see the business covering its fixed charges over time; see fixed charge coverage ratio.
• Diversified customers, so that concentration limits do not strip out most of the base.

Moving takes planning. The new lender pays off the factor at closing, the factor's lien is released and its UCC filing terminated, any purchased invoices still outstanding are settled, and customers are told to redirect payments to the new account. Some factoring agreements carry minimum volumes, termination fees or notice periods, so read yours before starting. Inventory can come into the ABL base too, typically at up to 85% of net orderly liquidation value, or roughly half of cost; see how lenders advance against inventory.

What each asks you to provide

A factor starts with the invoices: the schedule of receivables to be sold, customer names and balances, and proof of delivery or acceptance, plus the business's existing liens, since the factor needs a clean first position on what it buys. A business financing specific orders before they are invoiced is in purchase-order or contract finance instead, which asks for the purchase orders, supplier quotes, the last three months of bank statements and the debt schedule showing existing liens.

An asset-based lender asks for more of the business: an AR aging by customer with days outstanding, an AP aging, a balance sheet, a P&L and year-to-date P&L, the debt schedule and UCC position, an inventory report if inventory is part of the base, and often bank statements and two to three years of tax returns. Before closing it will usually run a field exam to test the receivables and the reporting.

Factoring is not a merchant cash advance. A factor buys specific invoices from customers who owe you; a cash advance buys a slice of future sales and collects daily. Businesses carrying cash advances often have receivables that could support a factoring facility or ABL line at far lower cost; see refinancing merchant cash advances.