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Although factors have existed in one form or another for more than 4,000 years, they have not been well known to the general public, primarily because they serve highly specialized markets. Factors extend financing to a client company by buying the company's accounts receivables, for which they pay 70 to 80 percent of the value of the invoices. Often, a client company will use the funds to fill a large order from a new customer. (Banks often won't provide the credit, because even though the company has the order, it usually does not have the overall net worth a bank would require before making a loan.)
When the client's other customers pay their invoices, they pay them to the factor, who then pays the remaining value of the invoice to the client company, after subtracting a discount fee plus interest for the period between the advance and the customer's final payment.
Dmitri Papademitrou, executive director of the Jerome Levy Economics Institute of Bard College, argues that factors should be encouraged to grow in areas which are underserved by traditional financial institutions. Their experience in dealing with small businesses means they can help fill the credit void left by commercial banks--a void felt most acutely by small, minority-owned businesses.
New Areas
Papadimitrou notes that factors were the dominant form of financing for companies in colonial America. More recently, factors were found primarily serving small-to-medium-sized companies in the textile and apparel industries. In the past 15 to 20 years, however, factors have come to serve a wide variety of industries, such as health care-related products, electronics, housewares, and furniture.
Partly as a result of that expansion to other industries, the volume of factoring itself has mushroomed--from $26 billion in 1978 to $46 billion in 1988, and $60 billion in 1994. At the same time, the industry has consolidated. The number of larger factors dropped from 35 in 1983 to 15 in 1993.
Small Businesses Benefit
Papademitrou points out that the factoring relationship is very useful to small businesses. Factors enable companies to get financing they can't obtain from banks, because the factor-client relationship is based as much on the financial strength of the client's customers as on the client itself. The loans factors make enable their clients to expand their operations and strengthen their balance sheets. In addition, factors often provide collateral business services, such as bookkeeping or collection services, which enables the client company to focus on what it does best.
There are, says Papademitrou, three categories of factors operating today. First is the so-called megafactor. These are the largest factors, and are mostly subsidiaries of bank holding companies. They serve primarily medium to large-sized corporations.
The second are "niche" factors, which serve "small to medium clients in a particular industry without regard to the community in which the client is located," although clients are generally at least in the same region. Niche factors usually provide a broader range of business services, are willing to accept smaller minimum fees, and serve clients with less equity than will the megas.
Finally, there are community-based factors, which focus on a specific geographic area rather than an industry. Like the niche factors, community factors typically provide their clients with a wide range of services. Their clients often are even smaller than those of niche factors--sometimes with annual sales of less than $100,000.
Funneling Credit to Communities
Because of their unique capabilities and intimate knowledge of their markets, says Papadimitrou, community factors are well-suited to the task of funneling credit into communities which have been underserved by conventional financial institutions. They could be encouraged to do that in a number of ways. Among these are allowing loans made by bank-owned factors to count towards fulfillment of the parent bank's obligations under the Community Reinvestment Act, encouraging community factors to become subsidiaries of community development banks, or allowing factors to qualify for funding under the Community Development Financial Institution Act.
Papademitrou believes that "increased lending to small business can help expand employment opportunities in distressed communities. Community-based factoring can meet that challenge and provide much-needed opportunities in those communities."
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