Recourse vs non-recourse factoring: who carries the loss when a customer doesn't pay?

Who carries the loss, invoice by invoice

Every factoring agreement answers one question: when a customer does not pay an invoice the factor bought, who absorbs it? Under recourse, the answer is almost always you. Under non-recourse, it is the factor, but only for the specific reasons the agreement lists. The easiest way to see the difference is by what actually goes wrong with invoices:

Non-recourse covers a customer who cannot pay. It rarely covers a customer who will not pay.

Why non-recourse is narrower than it sounds

Most unpaid invoices in an operating business are not unpaid because the customer went broke. They are unpaid because of a disagreement about quantity, quality, timing or pricing, or because the customer took a deduction. A factor buying invoices under non-recourse is pricing only the insolvency risk, and it protects itself against everything else in three ways.

• The definition of a credit loss. Usually a customer's bankruptcy, insolvency or failure to pay for financial reasons within a set period after the due date. The narrower the definition, the less the protection is worth.
• Your warranties. When you sell an invoice you warrant that the goods were delivered, the amount is owed, and there is no offset or dispute. If any of that turns out untrue, the invoice goes back to you regardless of what the agreement is called. This is the same idea as the validity guarantee an asset-based lender asks for.
• Customer approval and credit limits. The factor decides which customers it will cover and for how much. Invoices to unapproved customers, or above a customer's limit, are bought with recourse or not bought at all.

So the practical question is not whether the agreement says non-recourse. It is how much of your actual bad-debt history would have been covered. If your losses have come mostly from disputes and deductions, non-recourse would have protected you from very little.

How pricing and advances differ

Factoring is priced as a discount on each invoice, usually charged by how long the invoice stays outstanding, plus any service fees. On top of that, the factor advances part of each invoice up front and holds the rest as a reserve until the customer pays.

Non-recourse typically costs more than recourse for the same invoices, because the factor is carrying a risk it would otherwise hand back to you. It may also come with a lower advance, a larger reserve, shorter credit limits or a narrower list of approved customers. Recourse factoring is usually cheaper and more flexible about which customers it will buy, because the factor can always look to you.

Compare offers on what an invoice actually costs at your customers' real payment speed, including the recourse period and any fees for invoices that are bought back, not on the headline rate. A recourse agreement with a short recourse period can force you to repurchase slow-paying invoices from good customers, which works like a cash call at the worst moment.

Which one fits which business

• Recourse tends to fit a business whose customers are creditworthy but slow, whose losses are rare, and which wants the lowest cost and broadest customer coverage.
• Non-recourse can make sense when a meaningful share of receivables sits with a few customers whose failure would seriously hurt you, and the factor is willing to approve those customers at useful limits.
• Neither solves a dispute problem. A business with frequent billing disputes or heavy deductions needs to fix its invoicing and documentation before any receivables lender will value those invoices fully.

Businesses concerned mainly about a customer's insolvency sometimes buy trade credit insurance and pair it with a recourse facility or an asset-based line, rather than paying for non-recourse inside a factoring fee. Some asset-based lenders give more credit to insured receivables. Whether that is cheaper depends on the policy and the lender.

Compare against a bank line or ABL first

Among smaller companies, factoring of either kind mostly serves businesses a lender cannot yet underwrite: young, thinly capitalized, growing faster than their balance sheet, or with results a bank will not rely on. An established business with reliable monthly financials and a clean receivables aging is usually paying for work it does not need. Its better options are:

• A bank line of credit, sized on receivables and earnings, if the business fits a bank's credit policy. See line of credit vs term loan.
• An asset-based line, which lends against a borrowing base. Asset-based lenders typically advance 80% to 90% of eligible receivables, receivables more than 90 days past invoice are typically ineligible, and any single customer is commonly capped at 20% to 25% of eligible receivables.
• An SBA working capital line, where the business qualifies. See SBA CAPLines vs a conventional line.

Both an asset-based line and a bank line are full recourse: they are loans to the business. That sounds worse than non-recourse factoring, but in practice an unpaid receivable in a borrowing base simply drops out of availability, and the business keeps its customer relationships and collections. For most established companies a line's lower cost outweighs the credit protection given up. See factoring vs asset-based lending.

Getting out of a factoring agreement

Read the term, notice period, minimum volume and termination fee before signing, because they decide what it costs to move on. When moving to a line, the new lender pays off the factor at closing, the factor's lien is released and its UCC filing terminated, and customers are told to pay the new account. See moving from factoring to a line of credit.

Note that SBA will not refinance a factoring agreement. A business leaving factoring for an SBA-backed facility needs to plan the payoff from another source or through a conventional or asset-based line first.

An asset-based lender will ask for an AR aging by customer with days outstanding, an AP aging, a balance sheet, a P&L and year-to-date P&L, a debt schedule showing existing liens, an inventory report if inventory will be in the base, and often bank statements and tax returns. See what lenders look for in an AR aging.