A Blueprint of the Funding Relationship – What You Really Must Know
Howard J. Kane, Esq. & Kane Investment Group experts in the M&A field. - July 17, 2017
Howard Kane has been a leader in the staffing industry since 1969. Article Reprinted from Staffdigest Magazine 2005. Reprinted with permission.
Staffing companies are inundated with direct (snail) mail, telephone calls and on-line advertising from payroll funding companies, factors, banks and others wanting you to finance your accounts receivables with them. They offer images of dollars floating down from the heavens; of shopping carts full of cash just waiting for you to take a handful. If it were only that easy, wouldn’t that be nice? In reality it is a complex financial relationship that requires you to enter into a world of technical financial language and sometimes legal “gobbly-gook.” Understanding this process will help you navigate that complex world of A/R funding.
But don’t get me wrong, these vendors to the staffing industry provide a real and very valuable service to the staffing industry’s negative cash flow challenges. You need them as much as they want your business. However, selecting the right source of funds for your company demands that you understand the contractual relationship that you are entering into. Don’t be naïve and think that this is a handshake relationship, because it is anything but that. Most sources of A/R funding require that you sign a thick multi-page contract prior to lending you money. Anyone who has financed the purchase of an automobile can easily recall being presented with reams of paperwork to sign before the dealership delivers your vehicle. It’s the same thing with funding.
I. Terms of the Agreement, Cancellation and Termination:
It is common in the funding industry to require that you obligate yourself for a period of time or the “term” when you enter into their agreement. The actual term can be from 30 days to many, many years. You need to feel comfortable that whatever the length of the agreement you select, that you are comfortable being obligated for that period of time. It might be valid to look at this as marriage for a time-definite. This is both your marriage contract and your pre-nuptial agreement.
Once you contract with your funding source of choice, generally you will not be permitted to subsequently cancel the agreement, or to stop funding with them without some incurable default on their part. Some funding sources will only require a “simple notice without a material default having occurred” when you want to cancel this agreement. However, and more commonly, funding relationships are for a fixed period of time and you can’t terminate them without incredible difficulties and possibly significant financial penalties.
Recognize that it is a legitimate interest of the funding source to want to have you as a client for at least one year and up to two years. It takes time for them to make their anticipated profits. Therefore a staffing company that wants a 30-day contract or the ability to cancel upon 30 days notice may face higher finance charges than a client committing to a longer period. You have to be the judge of reasonableness, balancing the competing interests of the two parties.
When negotiating the term of the agreement with you source of funding, you will have greater leverage if your financed weekly gross invoices are significant in dollar terms. Therefore, many start-ups and small staffing companies may face less leverage with the funding source.
Most funding agreements have an automatic renewal clause in them. Often called an “Evergreen” clause, it causes your agreement to automatically rollover without you doing anything. When you sign your funding agreement, look for that rollover clause. It may require that you give your source of funds from 60 to 120 days advance written notice of your intent to cancel before the end of your agreement. Without that written notice, in a timely fashion, you will have silently agreed to a new term
II. Finance Charges and Rates:
Rates or finance charges vary wildly and rate shopping is appropriate. There are two distinct types of financing: funds only and funds provided with back office support (invoice preparation, payroll taxes paid, payroll checks, etc.) often called “Full Service Funding”. Understandably the full service option will cost more than the bare bones of the funds-only options. Some of what follows applies to funds-only relationships.
Generally, the full service companies quote you a flat percentage rate for their services and do not calculate the finance charges on the number of days your invoices are outstanding, like the funds-only companies do. Typically the full-service companies charge in the range of 2.75% to as high as 8% (or more) of the face value of your invoices. The funds-only funding companies have a myriad of rate programs or finance charges based on the number of days your invoices go unpaid.
Before calling these funding sources, one fact you should know which will help you to understand your anticipated cost of money is how many average days are your invoices outstanding. Create a simple spreadsheet for yourself listing your clients and then track the past few months between the day you invoiced your customers to the date that you received payment. Weigh the bigger clients more heavily than the smaller ones. If one customer represents 20% or 30% of your business and it pays you in 45 days, it matters more than if a customer who represents 5% or your business pays you in 25 days.
The funds-only sources may offer you a rate of as low as 1.0% for 10 or 20 days. Sounds great, eh? But it’s really a “so what!” Who pays you in 10 or 20 days? You need to look at what I will call the effective rate and your real cost of money. That is the rate or finance charge you will really incur for the number of days your invoices are unpaid. You may also have a variable to consider before you know your effective rate. It’s called by a number of names including “clearing days”. Before the source of funding stops the clock on counting the days your invoices are outstanding they may add some additional days to it. Ask about this and check your agreement. (For more discussion of this see the “Reserves” section below).
Rate formulae vary greatly. Some funds-only companies offer a daily rate (i.e. .075%) for each day they finance your invoices and others can offer periodic rates (i.e. 0-30 days = 1.85%, 31 – 45 days = 2.75%, 46 – 60 days = 3.5%). Other sources of funding have a flat fee charge (i.e. 6% flat rate) of the gross invoice value then subsequently reduce that amount – determined by when your customers pay the invoice. Be aware: there is no industry standard! Your own negotiating ability is critical here. Don’t hesitate to use a qualified financial professional to help you in this process. It’s your bottom line that’s at risk here.
III. All Fees, Costs and Expenses:
Some sources of funding also have other fees, costs and expenses. This is normal and varies greatly from one source of funds to another. It is always important to know what additional expenses you may incur. There may be application fees; bank transfer fees; express mail fees; credit checking fees; batch invoice fees; and so many more. Be sure to ask.
Advances are simply the money that is being advanced to you for your A/R and is generally expressed as a percentage of the gross invoice amount. If your invoice is $1000, and you are going to receive an 85% advance you should receive $850.
A prerequisite to receiving this advance will be the submission of satisfactory documentation to your funding source to prove that you have finitely earned this money and that it is legitimately due to you from your customer. What documentation does your source of funds require? How do they want you to transmit the documents to them, i.e., express mail, facsimile, e-mail, other?
When are the funds advanced? If you submit your invoices to your source of funding on Monday at noon, for example, when will your bank receive their funds transfer? Are there operational stipulations (generally not stated in your agreement) that prescribe specific times to submit invoices in order to receive funds when you need them? It’s possible that invoices submitted at 3:00 p.m. won’t be processed until the next day. That may delay a funds transfer. How is the money transferred to your account, i.e. by ACH transfer, by wire transfer? How long will it take for you to receive your advance funds (immediately, 24 hours, 48 hours?).
Are there charges for the funds transfers and if so, how much?
When do finance charges begin to accrue: on the invoice date or on the date the funds are actually transferred?
When does the clock stop on these charges?
An explanation of “Reserves” is in order as synonyms for this term may be used by different sources of funding. An explanation is easiest accomplished by example. If the source of funds advances the staffing company 85% of the gross value of the invoice, the remaining 15% is considered the reserve amount. Advance (85%) + reserves (15%) = total invoice amount.
Most sources of funding utilize a “lockbox” at some bank unaffiliated with the funding entity. Is there a charge to the staffing company for the use of the lock box or is it free?
Is the lockbox in close proximity to the staffing company’s customers? If you are a Missouri-based staffing company will your customers be mailing their checks to a lockbox in Boston, MA or to a local lockbox in Kansas City, MO? The important difference may be another day or two in the mail before your customer’s payment is received at their lockbox. That may be a couple of more days for finance charges to continue to accrue.
When will the finance charges stop accruing? Is it when the customer’s payment is recorded as being received at the lockbox? Is it when their check “clears” the processing bank -this is also called “clearing days”. This is when the funds are officially credited to the account of the funding source. Whatever the case, it needs to be factored into your financial and cash flow planning. You need to ask about this.
Now that your customer’s payment has been received by the funding source, when will you receive your reserves? Will they send it to you immediately? Will they impose a waiting period? Some funding source agreements provide for “clearing days” as mentioned, delaying the date you receive the reserves. There is significant variance in the funding industry, from one company to another, with the practice of releasing reserves. Some funding sources release your reserves immediately; some impose a waiting period of from one week to one month. As this affects your cash flow, this is an important item to define up front.
VI. Termination of the Funding Relationship:
Look at the agreement and define clearly how you may exit that relationship should you want or need to do so. If simple notice is all that is required, with “no cause for breach” as a prerequisite – that is the best option. However, it is common in these agreements to see draconian termination penalties which may amount to tens of thousands of dollars if you terminate without cause or request an early termination. Understand these liabilities going into the transaction, not when you want to exit the relationship. I believe most funding sources will be negotiable on this clause, but not willingly. They have a legitimate interest in keeping you as a client for a period of time, and it’s not worth it to have you as a client for just a few months. If you need a “bridge loan” go to your bank and use something like a home equity loan, not the funding company. Loans from many sources of funding may be quite significant.
If you do end your financing relationship with your source of funding, be sure to ask for a termination of your UCC-1 (see below).
VII. Staffing Industry Specific: Is that Important?
I think so. There are literally scores of funding sources advertising and marketing to the staffing industry. Some are generalists, meaning they also finance trucking companies, funeral homes and retail chain operations. Some are only serving the staffing industry. The generalist knows the financial process of providing you with funds as well as the staffing-specific funding companies, but do they truly know the intricacies of the staffing business? Probably not. If I was a staffing company owner, I’d like to talk with a funding source representative that understands my business and who has worked in my industry. Both have the dollars to give you, but one speaks your language, the other one doesn’t. This should be one of your considerations when selecting a funding source.
Here’s a short example. I know of one staffing company owner who got a fabulous job order for over 300 light industrial workers for a multi-month period with a Fortune 500 customer. That was the good news. However, when she approached her source of funding, they wouldn’t increase her credit line or the contracted to gross loan amount to accommodate this opportunity. Instead they told her to take a second mortgage on her house and more. The story turned out well as her customer agreed to pay her net 14 and she got the business. As she was not required to finance all of her invoices (another question to ask your prospective source of funding), she self-funded this client. A source of funds should let you grow your business, not limit its growth. If representations are made to you about flexibility on the ceiling amount that you can finance, get it in writing.
VIII. How Long Will You Be Financing Your Business with a “Payroll Funding Company?”
Tough answer to give you. It should be axiomatic that at some point in time a staffing company will have an operating history that will allow it to secure a simple line of credit with a traditional bank and at a substantially lower rate. That is not to say that there are staffing companies whose revenues are $20 million+ who still fund through typical funding sources other than banks. However, most at that level have gone “traditional”. With that said, banks can play extreme hardball with their clients possibly to your detriment. Market conditions change (think recession) and the banks (usually regional or local ones) exit the funding market; they make a policy determination to get out of that business (for now) and they can cut you off with 30 or 60 days notice. Or your business may be growing exponentially and they don’t want to take on a bigger risk in their A/R financing portfolio, so they don’t increase your credit line. The result of which may be that you can’t capitalize on growth opportunities.
You have to remember to revise your business plan regularly. Market conditions and the cost of money changes all the time. There will be a right time to switch, but be careful and do it intelligently.
A good source of funds recognizes that you will be their client for a short period of time, maybe three or four years. Thereafter you should be able to command lower rates with a line of credit or an asset based loan of some type.
IX. What’s a UCC? Is that important?
The “UCC” stands for Uniform Commercial Code. The UCC is a nationwide standardized set of regulations governing sales transactions protecting lenders, borrowers, buyers and sellers.
When most funding sources lend you money they file a UCC-1 with your Secretary of State, or a similar office in your state government. They want to put all other lenders on notice that they have a lien on some or all of your business assets until your obligations to them are satisfied. When examining A/R funding, many staffing owners are surprised to find that there is a UCC-1 already on file for their company. This means that there may be some line of credit or loan taken out that you thought was purely “personal” in nature, but that included your business; a previously satisfied financial obligation that was satisfied but that the lender didn’t “release” its UCC-1. If it’s the latter case, you need to call that earlier lender and get proof that they terminated their UCC-1 or have it done now. Many company owners didn’t know that even the Small Business Administration files such a notice when they lend you “start-up” money.
Effectively no other source of funds will lend you money if there is a UCC-1 filed against your business. In staffing you know that you A/R is your biggest asset. In the financial services industry the “first person in line” for your assets owns you. No other lender generally wants to be second in line in case of a default.
When does the source of funds file a UCC-1? This also varies from one source of funds to another. Generally when you sign their agreement, prior to receiving funding, a UCC-1 is filed. Some wait until they actually begin funding or transferring funds to you. If you signed an agreement and then are subsequently rejected for lending for any reason, always ask about this. Ask for appropriate documentation (UCC-3) for your files.
X. Will the Source of Funding Have Contact With Your Customers?
Most probably. This again has to do with protecting the lender to insure that they receive payment from your customers. Note: not all sources of funds have contact with your customers, but most do.
The UCC, related regulations and laws generally say that if your customer has constructive notice that there is a funding source (factor, bank etc.) for your A/R; that your invoices are owned by that funding source; that your customer’s payments are to be made to that funding source only, and if they pay you or anyone else instead – your customer is liable for a double payment. They are still obligated to pay the funding source again and try to get restitution from the staffing company for the double payment. Essentially, they have to notify your customers. Limited exceptions exist out there, so ask. In addition, many funding sources are now requiring your customers to acknowledge receipt of this notification.
However, if there is no notification to your customer then the funding source is left to collect their money by seeking the funds from the staffing company directly and if necessary, by holding the staffing company’s officers personally liable.
The best advice is to ask the funding source if they will have contact with your customers and, if they do, for information on exactly how they notify your customers of your financing relationship with them. This notification can be nice or not so nice. Don’t get unnecessarily upset about this. Financing your A/R is very common and not to be thought of as “uh oh, my clients will think I am a sinking ship”. Some of the biggest U.S. companies use similar financing and most customers are sophisticated and accustomed to it as “business as usual”.
Some funding sources do not contact your customers at all, in any way. So if that’s critical to you, do your due diligence before you sign on the bottom line.
XI. The Application Process
Be prepared! Nothing is easy and the funding source has every good reason to look at your prior bank statements, tax returns, personal and business credit history and more. They have every right to do their own due diligence on their prospective clients. 98% of the staffing industry is made up of honest and hard working business people. Even if you have spotty credit, it may not matter at all. Bankruptcies, recessions, tax liens are all a part of a business and personal life history. They know that. But the 2% (and hopefully less) remaining may be dishonest people who make their living defrauding these honest sources of funding with quite intricate schemes. The sources of funding have a legitimate interest to protect themselves.
I can’t tell you how many prospective customers for funding have been overwhelmed when they see the document request that is presented to them by their prospective source of funding. The staffing company owner may feel it’s invasive and intrusive and would rather go it alone in lieu of providing the requested information. Be forewarned. But it is worth it in most cases to work with your source of funds and be forthright about the good and bad of your financial experiences and history. They will find out anyway when they do their due diligence, so just go with the flow. These sources of funding want your business and they are all professional in their dealings with you.
Requesting references from the prospective funding source is generally a waste of time. The funding source will provide you with an A-list of clients as long as your arm. I’m not suggesting not to ask for this, but suggest an additional course of conduct for you. When you attend a local chapter, state or national staffing association meeting network with other staffing company owners, ask about their experiences with particular funding sources. A funding source recommended by your “competition” is better than choosing a source from some directory. Be a smart shopper! If you can’t for one reason or another get to some association meeting, call a well-known staffing company in your community and speak to one of their senior people or the owner(s). My experience is that well-established industry members are very generous and won’t be imposed upon by such a request.
Here is some advice from one of the staffing industry’s most prominent funding executives, Marty Orenstein of Funding Fanatics, a division of Marty Orenstein’s Staffing Network:
“The staffing industry has encountered turbulence a number of times in the past two decades. Staffing industry entrepreneurs have had to contend with the financial devastation caused by recessions, 9/11 and utterly flat markets. Fortunately, today’s climate is one of unbridled growth and hopefully stability.
Therefore, any restriction on your ability to grow your company due to a lack of adequate capitalization is inexcusable in today’s expanding staffing arenas. Of course, the cost of money is always a concern. However, inexpensive funds that don’t provide the availability required to build your revenues to the fullest are shortchanging you. At some point in time we will all sell our companies. Without available money, to do so might cost you hundreds of thousands of dollars when you sell your business. When shopping for financing you must give equal consideration to both of these factors.
Most importantly be sure that whatever type of lender (banks, asset-based lenders, factoring companies and payroll funding companies) that you are considering understands the intricacies of our “simple” industry. The future is now and knowledge is power!”
My conclusion is that receiving necessary accounts receivable funding is essential to keeping pace with the growth opportunities you work so hard to achieve. However your need still requires that you do your due diligence intelligently. Approach this transaction armed with the facts.