I LOVE accounts receivable (AR) financing for two reasons:
1) It’s inexpensive, readily available, super flexible debt you can use to make a closing payment on a business.
2) It’s a great line of credit (LOC) for you to grow the business once you own it.
First, let me specifically explain what AR financing is…
AR financing is when financier loans a business money against its unpaid book of customer invoices based on the quality of those invoices.
AR financing (let’s call it ARF for short) is also called CID — Confidential Invoice Discounting — in Europe.
Don’t confuse ARF with factoring.
Factoring is where the business sells its invoices at a discount to a third-party who then collects the debt from the customers, often through aggressive tactics. (I don’t recommend this.)
To successfully raise ARF on a deal, the business needs to be a B2B — a business that sells to other businesses. Consumers typically pay by cash or credit and are rarely (if ever) extended credit by a business.
ARF lenders also won’t fund businesses with any sale or return policies on products or services.
So ARF deals are B2B.
Now, there are some factors regarding the outstanding invoices that are important for ARF.
Age of Invoices
Typically, ARF only works with invoices that are less than 90 days old. Some financiers might go up to 120 days, but 90 days is much more common.
That means if your target business has invoices that haven’t been paid after 90 days, they will be considered delinquent, suggesting the customer may have a cash flow problem and is unlikely to pay.
Quality of Customers
Second, ARF providers will run credit checks on each of the business’s customers.
If it has customers with poor credit, expect those invoices to be excluded. ARF providers insure the invoice balances so they are made whole if a customer never pays.
Finally, the ARF lender typically doesn’t like to see any single customer represent more than 25% of the business’s total revenue.
So, if 50% of the revenue comes from one customer, expect that HALF of those invoices will be excluded.
So… you need credit worthy customers with a maximum 25% concentration and invoices outstanding for less than 90 days.
For qualifying invoices, you can get up to 95% of the total outstanding balance, including sales taxes and VAT.
If you want to estimate conservatively in your valuation model prior to seeing the business’s detailed invoice reports, assume a 70% to 80% loan-to-AR ratio.
For example, let’s say the business has $500K of unpaid invoices making up its AR (also called trade debtors in Europe) with a 60-day average payment time.
Subject to due diligence, the financier is likely to commit between $350K to $400K in financing.
Next, let’s look at the power of ARF in the business once you own it.
Assume from the last example, your business had $500K of AR at closing and you financed $350K of it.
Once those outstanding invoices have been paid, the financier will take back their $350K and give you the $150K that wasn’t financed.
That $500K is two months of working capital tied up with customers who haven’t paid yet.
They want you to use the facility — a revolving line of credit (LOC) — to finance any new invoices you send out.
Say the day after you close the deal the business generates a new $10K invoice.
The invoice is loaded into the AR facility and, if it qualifies, up to 95% of its value ($9.5K) will be converted to cash within 24 hours.
ARF reduces the outstanding payment time MASSIVELY — to just one business day.
That’s a great boost of working capital to the business… and one of the reasons we can use it to fund a closing payment without suddenly opening a huge cash flow gap.
If you continue to trade the business — or better still, grow it — you will improve the cash flow cycle of the business.
In summary, ARF is GREAT because…
1. It allows you to leverage unpaid invoices to raise cash for a closing payment
2. It gives you rocket fuel to grow the business without worrying about cash flow.
Until next time, bye for now.