A collections agency is often confused with a company that buys debt or a company that loans money using accounts receivable as collateral. Although all three of these options can be used to improve cash flow, and each has advantages and disadvantages.
First, a collections agency is a company that collects debt on your behalf. They are usually hired to collect debts that are in default and are compensated with a percentage of sums collected. Rates will vary based on the type of collection, the aging of your debt and other factors. Most agencies work on a “no collection, no fee” basis.
Benefits include the fact that a collections agency can work on debts with any aging within the statute of limitations, which varies by state. Also, they may offer additional services such as credit bureau reporting and the ability to research or “skip trace” files to find your delinquent customers who move. The potential downside is that you do not receive your money immediately, but have to wait until the agency collects it, which could take some time.
Companies that buy debt are commonly known as factors. Factors pay you the face value of your invoices, less a fee. There are two kinds of factors: recourse and non-recourse. In a recourse arrangement, the factoring company retains the right to collect from you if the customer does not pay them. In a non-recourse arrangement, the factor takes part or all of the risk of customer non-payment. Factors generally collect the money or hire a collections agency to do it.
The advantage of factoring is that you get cash quickly. Factors generally buy more current invoices and will perform due diligence of your customers to assess their ability to pay. Factors may decline to purchase invoices they deem too old or two risky. Or, if they do, their fees for risky invoices may be so high that you do not get much benefit. Factors also tend to work with companies that have a great number of invoices, so you would need to have volume to make it work.
Lastly, there are companies that will lend you money taking your accounts receivables as collateral, commonly known as invoice financing. You would “pledge” your receivables as collateral, not sell them. The lender would underwrite your customers before making the loan, so this approach also is only available for current invoices. You are responsible for collecting payments from customers. This approach also provides quick cash and works like a traditional loan in many ways. However, interest rates are normally a good deal higher than traditional loans, due to the risk of customer default. Again, you would need a volume of current invoices to interest the lender.
Each approach has a place in helping with cash flow. Each also underscores the importance of managing your credit risk by carefully evaluating your customers before you grant them credit. Gather and verify trade and bank references. Clearly outline the terms of your arrangement in a customer contract. In some cases, such a start-up or a company with less than stellar credit, require a personal guarantee that will protect you by attaching the owner’s personal assets if the company goes out of business.
You may use one or all of these approaches at some point with your business. They can all work well, especially if managed by you in conjunction with your active oversight and management of your credit practices.