Invoice factoring companies do not require their customers to provide collateral other than their accounts receivable. Because of this, it is critical that the factor feel extremely confident that the client’s client will “reimburse” them. Progress billings, which are typically present in construction relationships, are generally not compatible with accounts receivable factoring.
First, it is important to understand the mechanics of factoring. Here are some of the most important concepts to know:
- The customer must produce goods or services that it sells to another company.
- The client must be creditworthy (always pays in a timely manner)
- Accounts receivable must be free of charges. This means that no credit institution, government agency, business, or person can have a lien on accounts receivable. To establish a factoring contract, the bond must be extinguished so that the factoring company can have a first position in the guarantee
- Long-term accounts receivable or contracts cannot be factored. When an invoice is not paid after 90 days, most factoring companies expect the customer to replace that invoice with a new one.
- The factoring company must be able to verify that the invoice is correct and that it will be paid by contacting the customer.
- Invoice payments must be made in a safe deposit box controlled by the factoring company
- Goods or services related to the invoice must be complete
It’s the latter item that warrants attention, especially with construction factoring or other situations where payments on a contract are made over the term. Progress billing is present when there is typically a long-term project with a final result. An example might be a contractor building a water tower for a city. Since the finished product won’t be completed for quite some time, the city allows the builder to bill them in monthly installments. But there hasn’t been a milestone.
In other words, even though the contractor is moving forward with the project, the city will not be satisfied until the water tower is fully completed. In this situation, factoring companies are wary of advancing funds on billing. If for any reason the contractor decides to walk away, the city would consider the company in breach of contract and likely 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 the invoices. Let’s say the project consists of building several statues in the city parks. The city allows the contractor to bill them each time a statue is completed. This invoice would be “factorable” since a milestone has been set.
Although the topic of billing for progress against milestones is more present in the construction industry, it can be applied to other segments as well. Another example might be a marketing company developing commercials for a major network. The company bills the network periodically until the commercial is complete. Are these progress billings or have milestones been established?
These issues can often be resolved by incorporating certain language into the contract that establishes milestones. Remember, the factoring company simply needs to have a level of confidence that the debtor will pay them.