Factoring Agreements: 10 Essential Terms

Your apparel business is doing well and, instead of continuing to use your own financial resources or borrowing from family and friends, you are seeking third-party financing. You are now ready to begin discussions with various financial institutions about factoring your company’s accounts receivable.

What Is a Factoring Agreement?

A company and a factor enter into an agreement in which the factor purchases a company’s accounts receivable (such purchased accounts are called factored accounts), collects on the factored accounts, then pays the company the purchase price of the accounts. In addition, if the factor approves an order from a creditworthy customer of the company, and the customer thereafter fails to pay the factored account solely as the result of the customer’s financial inability to pay (i.e., due to insolvency or bankruptcy) and not as the result of any type of dispute or other reason, the factor will still pay the purchase price of the account to the company.

A factor may also provide financing to a company by making advances, prior to the factor’s receipt of payments, against the purchase price of a company’s factored accounts. If a company is obtaining financing from a bank instead of a factor, the bank, the company, and the factor will enter into an agreement stating that monies otherwise payable to the company under the factoring agreement will be payable to the bank.

10 Important Factoring Terms

First, your company will probably receive a proposal letter (this is not a contract) from the factor containing some, but not all, of the business terms that may be in the factoring agreement. This proposal letter usually requires your signature and a deposit. The factor will then send you the proposed factoring documents including the factoring agreement, personal guarantees (if the factor is making advances), a Secretary’s or Manager’s Certificate (depending on whether your company is a corporation or a limited liability company), a proposed notice to your customers that your company’s accounts receivable have been assigned to the factor, and various related documents and agreements.

The factoring agreement is usually 10 or more pages long and may initially seem overwhelming. Following are 10 terms contained in all factoring agreements that you need to review and understand:

1. Sale and Purchase of Receivables. The factoring agreement will require you to sell all of your accounts receivable to the factor. Discuss with the factor any accounts that you do not plan to sell to the factor, such as credit card or COD accounts or accounts arising from your sales to specific customers.
2. Credit Approvals and Withdrawals and Disputes. Prior to shipping goods to a customer, you will be submitting the customer’s order to the factor for its approval of the creditworthiness of the customer and the terms of sale. An account receivable arising from the sale to a customer pursuant to an approved order or under a credit line is an approved or factor risk account. Accounts that are not approved or factor risk accounts are referred to as nonapproved or client risk accounts. You will not be able to change any of the terms of sale on an approved account without the factor’s prior written consent, and, in general, you must ship the goods in accordance with the factor’s written approval. The factor can change or withdraw a credit approval at any time before the goods are delivered to the customer, and, in such cases, the account receivable arising from the sale of the goods becomes a nonapproved account. In addition, if a customer alleges a dispute with respect to a factored account, the factor no longer has the credit risk on the account and the account becomes a nonapproved account. Be sure to discuss with the factor how much time your company has to work out disputes with customers before the account becomes a nonapproved account.
3. Invoicing and Assignment Schedules. Your company will be required to put a notice on its invoices to its customers that the invoices have been sold to and are payable only to the factor at a specified lockbox, and you will be required to turn over to the factor any payments your company receives on factored accounts. You will also be required to send the factor schedules of all assigned accounts and the related invoices and proofs of shipment or delivery.
4. Commissions. The factor will charge your company a percentage of the gross amount of the factored invoice as a commission, subject to a minimum, specified dollar-per-invoice amount. The factor will also charge an additional commission or surcharge on certain customer accounts based on the financial information the factor maintains on the customer. In addition, in almost all cases, your company will be charged a monthly, quarterly, semiannual, or annual minimum commission amount.
5. Payment of the Purchase Price of an Account. As a purchase price for each factored account, the factor will pay your company the net amount, generally calculated by deducting customer discounts, commissions, and credits, including merchandise returns, allowances, chargebacks, and all other charges from the gross amount of the account. The date your company is credited with the purchase price of a factored account is generally when payment is received from the customer plus a specified number of days for the clearance of the remittance (such clearance, or float days, may appear in the section of the factoring agreement addressing the computation of interest rather than in the section dealing with the payment of the purchase price of accounts). In addition, if an approved, undisputed factored account remains unpaid solely as the result of the customer’s financial inability to pay, the factor will credit your company’s account with the purchase price of the account at a specified time after its longest maturity date or after a bankruptcy or other insolvency proceeding has been filed by or against that customer.
6. Advances. The factoring agreement will provide for discretionary advances by the factor up to a specified percentage of the purchase price of approved factored accounts (and, in some cases, the factor may also make advances against the purchase price of nonapproved accounts). There will also be a dollar limit on the amount of advances that may be outstanding at any time. Make sure to discuss this limit with the factor since it may not be stated in the factoring agreement.
7. Obligations and Interest. The term “obligations” as used in the factoring agreement will be broadly defined and include, without limitation, advances, ledger debt (the amount the factor may debit your account for your purchases of goods or services from other clients of the factor), attorneys’ fees, wire fees, and any and all other amounts at any time payable by your company to the factor under the factoring agreement or any other agreement between your company and the factor. The factor will charge interest on the obligations at a per-annum rate equal to a specified percentage above the prime or other reference rate. The factoring agreement will also provide for a minimum or floor interest rate and for an increase in the interest rate under certain circumstances, such as a default under the factoring agreement.
8. Representations and Warranties. The factoring agreement will contain representations and warranties that your company is solvent, duly incorporated or organized, in good standing, and not in violation of any laws. The factoring agreement will also include representations that each factored account is bona fide and represents indebtedness incurred by the customer for goods actually sold and delivered to the customer; that there are no setoffs, offsets, or counterclaims against the account; that the account does not represent a consignment, bill and hold transaction, or cash-on-delivery sale; that no agreement exists permitting any deduction or discount (other than the discount stated on the invoice); that your company is the lawful owner of the account and has the right to sell and assign the account to the factor; and that the account is and will be free of all security interests, liens, and encumbrances (including tax liens) other than those in favor of the factor.
9. Termination Provisions and Events of Default. Most factoring agreements provide for an initial term of between one and three years with automatic renewals after the initial term. Your company will have the right to terminate the factoring agreement at the end of the initial term or any renewal term by giving the factor usually 60 to 90 days notice prior to the end of the initial or renewal term. The factoring agreement normally includes an early-termination fee if your company wants to terminate the factoring agreement at any time other than at the end of the initial or renewal term. The factor will have the right to terminate the factoring agreement at any time (i.e., not just at the end of the initial or renewal term) by giving usually 30 to 60 days prior written notice to your company. In addition, the factor will have the right to terminate the factoring agreement immediately upon any default. The factoring agreement will contain a list of default events including, without limitation, your company’s breach of any of its warranties and representations in the factoring agreement or the filing by or against your company of a bankruptcy or other insolvency proceeding.
10. Security Interests and Remedies. The factoring agreement will provide for your company to grant the factor a lien on some or all of your company’s personal-property assets as security for the obligations your company owes to the factor. If your company is not requesting advances from the factor, the assets covered by the factor’s lien will generally include your company’s accounts receivable, any sums standing to your company’s credit with the factor, and certain other assets that relate to your company’s accounts receivable. If your company is receiving advances from the factor, then the factor’s security interest will also cover most, if not all, of your company’s other personal property including, without limitation, its inventory and intellectual property (such as your company’s trademarks). The factoring agreement will provide that if an event of default has occurred, then the factor will have the right to foreclose upon and sell the assets in which it has a security interest and apply the proceeds of the sale to the obligations your company owes to the factor.

Factoring provides a practical way for a company to have its accounts receivable credit insured and collected and to receive financing for the operation of its business. Be sure to carefully review all of the provisions of the factoring agreement, first on your own, and then with experienced apparel counsel.

Racey Cohn has been providing deal structuring and other business advice and guidance to major financial institutions for over 20 years. She has reviewed, drafted and negotiated documentation for multi-million dollar loan transactions, including factoring contracts; asset based lending agreements; license agreements; asset and stock purchase agreements; forbearance agreements, cash collateral and stock pledge agreements; corporate, limited liability company and partnership agreements; public and private foreclosures; landlord and warehouse waivers; guarantees; and real property collaterals.