What are the key considerations for an invoice financier, and the main pitfalls to avoid for a company seeking invoice finance?
Invoice finance (invoice discounting or factoring) involves a financier advancing a certain amount of working capital funds against a company’s invoices. It is therefore essential for the financier to understand the make-up of the company’s trade debtors (and to some extent suppliers) and the terms on which the company contracts with them.
What are the key considerations, and how can they be satisfied?
- Assignability of debts – under invoice finance facilities a company’s debts are usually sold to the financier at a discount (usually 80-90% of their face value). The financier will usually take a ‘back-up’ charge over debts that, for whatever reason, cannot be sold, but they are generally given no value by the financier. Restrictions on assignment in the customer contracts are a key issue for the financier. Where a restriction requires customer consent, currently the company has to decide whether to seek that consent (which could be time-consuming, and would prevent the financing being taken on a confidential basis (i.e. not disclosed to the company’s customers)) or to exclude that customer’s debts from the financing. Legislation is expected in autumn 2016 that may render non-assignment clauses unenforceable by a customer in an invoice financing, although the precise terms of the legislation are still unclear.
- Customer set-off rights – where there is a two-way trading relationship between the company and a customer, the invoice financier will not want the customer to have the right to set off amounts that the company owes to it against amounts that it owes to the company. This could prevent the financier recouping from the debt the amount advanced against it. The same would also apply to credit notes, discounts, write-offs and the like, which are together referred to as “dilutions” against the original amount of the invoice, and which will often be taken into account in determining the discount rate based upon the company’s historical debtor data.
- Dispute provisions – any invoice that is in dispute between the company and a customer will be ineligible for financing. It is therefore important for the company that its contracts have a clear process for resolving uncertainties and disputes as to the company’s performance of its contractual provisions and the customer’s right to withhold payments.
- “Contractual” debts – customer debts that comprise staged payments to the company by reference to an underlying contract (for example, under a construction contract) are typically less attractive to an invoice financer. Some financiers do specialise in so-called contractual debts, however some invoice financiers will only finance against known debts where the company has fully discharged its performance obligations to the customer.
- Retention of title rights for suppliers – where a supplier has supplied goods to the company that the company has used in the performance of a customer contract, any retention of title right that enables the supplier to “look through” to the company’s sub-sale proceeds and recover all or part of them can affect the company’s ability to receive the full amount of the invoiced debt when paid by the customer. Case law strongly suggests that any such claim is not enforceable, but an invoice financier may still insist on a waiver of retention of title claims from any large supplier to the company.
- Existing security over company assets – a company may have granted security over its book debts via a prior debenture, but whose primary focus was to grant security over other, tangible assets of the company. The other lender may be prepared to release the book debts from its security or the other lender may permit the financing of those debts but retain security over any debts that remain in the ownership of the company; in this situation a priority arrangement will need to be documented between the invoice financier and the existing lender.
An invoice financier will typically use an in-house team or instruct lawyers to review the terms of the customer and supplier contracts and the existing security arrangements of a company to assess the impact of these issues. Conversely, a company can best position itself for invoice financing by instructing lawyers familiar with these issues when preparing its customer and supplier contracts.
- Company credit control – a right to receive a debt is not the same as actually collecting that debt. If invoice financing is to done on a confidential basis, with the company continuing to collect in its own customer debts, an invoice financier will require a strong track-record of debt collection and credit control.
- Debtor concentration – an invoice financier will not want to be overly exposed to the underlying credit risk of the company’s customers. It will therefore analyse the credit strength of the company’s core customers. Is it not necessarily a negative for a company to have a small number of core customers if those customers present a low credit risk. However it is quite common for an invoice financier to impose debtor concentration limits on the company, meaning that it will not fund any customer’s debts to the extent those debts exceed either a specified percentage of the company’s overall debtor book or a specified monetary amount.
- Territorial restrictions – it is common for an invoice financier to exclude from the financing (i) any customer that is not based in one of a list of specified countries and (ii) any invoice that is payable by the customer in a currency other than one of a list of specified currencies. By the former the invoice financier insulates itself from the potential difficulties of bringing debt recovery actions against foreign companies, either in the English or foreign courts. By the latter the invoice financier insulates itself from the potential risks of exchange rate fluctuations of the payment currency against pound Sterling.
- Credit insurance - companies are readily able to insure against bad debts, and whether or not a company has credit insurance (and, if so, how robust the cover is perceived to be) will be taken into account by an invoice financier. Alternatively, where a company does not have standalone credit insurance, it can be provided by the invoice financier as part of the financing; this would incur a further charge but should improve the terms of the financing for the company. The question for the company is therefore one of risk and reward, much as when a company is considering a hedge product in the case of a standard bank loan.
An invoice financier will typically assess these issues as part of the financial due diligence that it conducts into a potential borrower before committing to the financing.