Recourse vs. nonrecourse invoice factoring: Read the fine print
Defining recourse and nonrecourse factoring
- In recourse factoring, the invoice seller is responsible if the client does not pay.
- In nonrecourse factoring, the factor is responsible if the client fails to pay.
- What is advertised as nonrecourse factoring is typically modified recourse factoring.
- Modified recourse facting protects the invoice seller only in certain circumstances.
For small businesses that can’t meet the stringent qualifications of a traditional business loan, invoice factoring may be a solution for quick cash. In addition to the costs of invoice factoring, another important consideration is recourse or nonrecourse factoring, part of the agreement that stipulates what happens if a client does not pay an invoice.
Factor companies assess credit
It is uncommon that clients fail to pay their invoices to the factor. This is because the factor typically conducts credit checks on the clients whose invoices it aims to purchase. The factor is more than just a collection agency. Similar to a lender, it is betting on receiving full payment for the invoice — and collects a fee from the invoice seller, meaning your business – for taking on that risk. Thus, the factor will do all it can to reduce the risk of an unpaid invoice. Part of accounting for this risk is deciding what course of action to take should the client fail to pay.
Recourse vs. nonrecourse factoring
With recourse factoring, the business — that is, the invoice seller — is ultimately responsible if a client fails to pay an invoice, and must repay the invoice amount to the factor. As the risk is on the business itself, recourse factoring typically carries lower fees than nonrecourse factoring.
With nonrecourse factoring, the factor assumes full responsibility for the invoices it purchases if the client does not pay. As the risk of nonpayment is now on the factor’s books, nonrecourse arrangements are typically more expensive.
The nonrecourse fine print
On the surface, nonrecourse financing seems ideal for the invoice seller: the business gets quick cash while washing its hands of the invoice altogether. However, few truly nonrecourse factoring arrangements exist once you read the fine print of a contract.
When exploring a so-called nonrecourse factor, read your contract very carefully. Typically, the details of the agreement state that the factor will assume the loss only if a client fails to pay its invoice “due to bankruptcy or insolvency.” This limits the nonrecourse clause to the very specific — and unlikely — scenario of client bankruptcy, ultimately leaving the business on the hook if the client fails to pay for other reasons. This is called modified recourse factoring, and is what many factors advertise as so-called nonrecourse.
Remember that a factor will not accept invoices from a client it does not deem creditworthy to begin with. So, the chances of your client becoming wholly insolvent are very low. If, however, your client fails to pay for any number of other reasons, not only will you be responsible for chasing them for money to pay the factor, you will be paying the higher fees of so-called nonrecourse factoring.
Which to choose
If you are factoring your whole ledger of invoices from repeat, trusted clients, recourse financing is usually a better option. Fees are lower and you assume less risk of nonpayment, particularly if you work with a reputable, experienced factor that can professionally collect payments from your clients.
If you are spot factoring a single, particularly large, invoice or an invoice from a client with dubious finances, paying the extra cost for modified recourse or true nonrecourse financing may make sense. While many invoice companies like to promote nonrecourse factoring, recourse factoring remains the more common arrangement.