If you’re looking for factoring services, you may have heard the terms recourse and non-recourse factoring. These are impressive legal terms that dictate what happens in a factoring arrangement if your customer fails to pay an invoice. I know, we dare think such terrible thoughts… but bad things do happen from time to time. If one of your customers doesn’t pay an invoice, someone has to pony up the funds… and it may be you. It depends on the recourse clause in your factoring agreement.
What is Recourse Factoring?
Recourse factoring makes you, the client, pay for any uncollected receivables. Most factoring agreements are recourse. If your customer becomes insolvent, defaults or goes bankrupt, then you're liable for the bad debt expense. Since your factoring company already advanced you the money for the invoice, you'll owe the factoring company the advanced amount plus applicable fees. The factoring company will get payment from you by either charging your existing reserve or directly billing you for the loss.
You may think recourse is risky. Nobody likes bad debts. If your customer doesn’t pay, then you could be out a lot of money. But one of the beautiful things about a good factoring company is they help you minimize exposure to losses and bad debts. Most factoring companies run credit checks and monitor your credit situation with your customers. If your customer’s credit appears bad then the factoring company will notify you.
Your factoring company can reduce your credit risk with trade credit insurance. You may incur a premium (up to 2%) for the insurance but you sleep better at night knowing your covered against a credit loss. If your customer's credit is really bad then the factoring company may not purchase the invoice. Then you must decide if you want to bill your customer yourself.
What is Non-recourse Factoring?
Non-recourse factoring holds the factoring company liable for uncollected receivables due to customer credit issues. Some factoring companies offer non-recourse factoring only. Other factoring companies offer a non-recourse option or an as-needed feature to recourse factoring. If you are risk-adverse and hate the thought of your customers not paying your invoices, then you may find comfort in non-recourse factoring. You’re off the hook. You sleep really good at night knowing your factoring company has your back. (But you’re still on the hook for certain situations. We’ll discuss this later.)
Non-recourse is the greatest thing in the world... right? No bad debts... Why wouldn’t you get non-recourse? Why even consider recourse? Well, most great things aren’t free, and non-recourse factoring is one of them. A factoring company isn’t going to take additional risk without some compensation. Additional risk in the finance world always translates into additional cost.
You’ll usually pay a premium (in the form of higher rates) for a non-recourse factoring agreement. If your customer base is solid and virtually risk-free, then you may still pay extra for a non-recourse agreement. Your customers change - they come and go. So remember, non-recourse isn't free.
Bottom line: Do not pay unnecessary premiums to insure your good-paying customers!
Simply a credit guarantee
So, why are you still on the hook if you’ve got a nice non-recourse policy with your factoring company. Most non-recourse factoring arrangements only cover non-payments due to your customers credit. Most non-recourse agreements are simply a credit guarantee. In other words, non-recourse factoring covers you only if your customer cannot pay for credit reasons like insolvency or bankruptcy. Non-recourse factoring doesn’t cover you if your customer doesn't pay for your product or service due to quality or disputable issues.
If you sell apparel to a retailer, but that retailer all of a sudden can’t pay it’s bills due to financial reasons, then you’re not liable under a non-recourse agreement. If you perform construction services for a general contractor and the general contractor goes bankrupt or defaults, then you’re not liable under a non-recourse agreement.
If you send your concrete customer 20 tons of sand, but they don’t pay because the sand is the wrong course, then you’re liable. If you perform electrical work for a high-rise and the wires don’t pass code, then you’re liable. If you ship freight to a warehouse and the goods are damaged on arrival, then you’re liable if your customer refuses to pay. Factoring companies do not pay for uncollected receivables due to customer disputes over quality or any other reason non-credit related. This is true 100% of the time - recourse or non-recourse.
One size doesn’t fit all
Factoring companies manage your accounts receivables and good factoring companies help you avoid bad debts. Non-recourse factoring for your credit-worthy customers can be overkill, especially if you're paying a premium for it. Look for a factoring company that offers a non-recourse option, only if you need it. If your customer base is risky, then non-recourse factoring may be a good fit. If risk isn't an issue, then you're better off with lower-cost recourse factoring.
Always look at factors other than recourse when searching for the right factoring company.
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