What The Hell Is Recourse?
When I was eight years old, I threw a bag of pastries out of the kitchen window and into a bush. To be specific, this was a paper bag — still warm — filled with 5 freshly-baked croissants, one for each of my family members. Of the three children in my family, my mom had chosen me to bike into town and pick up breakfast. This was a rookie mistake on her part, but we can save my rap sheet for another time.
Back to the bush incident. Arriving home and finding the kitchen empty, I placed the bag of croissants on the counter, next to a muffin my dad had been saving. I looked at the croissants, then looked up at the empty kitchen, then back to the croissants again, then finally at the kitchen window. I hesitated. Was I really going to do this? But I already knew the answer. In what seemed like only a few seconds (it was all a delirious blur), I cranked open the window, dropped the bag into a bush, snuck out the door, ran to said bush, climbed into said bush, and then proceeded to eat all of the croissants in total secrecy (and in one sitting).
Seeing as I’m writing this from a company account, allow me to begin weaving this story into the matter at hand: recourse in invoice factoring. Bear with me — the allegory is nigh. Just above the bush (where I was still sitting, and now mentally coming to terms with what I had just done), another scene was unfolding in the kitchen. My sister, hungry but unable to find her croissant, asked my dad if she could have his muffin. In exchange, she would give him her croissant when I came back with them. He agreed. She ate the muffin.
Because my sister was hungry, she essentially entered into a pastry factoring agreement with my dad. Breaking it down, we have the following:
- I am the debtor and my sister is the seller.
- The croissant is the receivable.
- My dad is the factoring company.
- The muffin is the advance.
- And recourse is what happens next, after my dad and sister realize that the receivable isn’t coming anymore, because it’s been eaten and I’m too full and ashamed to ride my bike into town again for another batch.
More technically, recourse refers to a factoring company’s financial protections when a debtor defaults on a factored receivable. Essentially, it defines who owes what, after it becomes clear that an expected payment isn’t going to be completed. A factoring agreement can have three types of recourse, which I’ll illustrate below, using my sister’s distressed croissant.
Type 1: Recourse Factoring
In recourse factoring, the seller bears the financial losses of a payment default. The factoring company is not held liable, and the seller must fully repay the factoring company. In other words, my sister still owes my dad a croissant, and has to get it to him somehow. Assuming she doesn’t have a separate stash of croissants hidden somewhere, she has to bike into town herself to go get him a new one. Because the factoring company is more financially protected, recourse factoring charges lower fees.
Type 2: (Actual) Non-Recourse Factoring
In true non-recourse factoring, the liability ultimately falls on the factoring company. Theoretically, this should cover all scenarios, excluding cases in which there is a dispute between the debtor and the seller. In this type of factoring, my dad bears the loss of the eaten croissant. My sister is not responsible for getting him a new one. Because of its increased risk, this type of factoring is uncommon and more expensive.
Type 3: (Advertised) Non-Recourse Factoring
In practice, many factoring companies who offer “non-recourse” are really presenting a hybrid version. You end up with something that functions a lot like non-recourse, but with many added caveats. Most commonly, the factoring company will only take on the liability if the debtor becomes insolvent. For example, the seller will not be required to compensate the factoring company if and only if the debtor declares bankruptcy. Factoring companies will also use vague language about warranties and covenants as a backup plan to try to send the distressed receivable back to the seller. It’s important to read the fine print.
Factoring companies are good at measuring risk, and they’re not going to put themselves into a dangerous position. Non-recourse factoring is often much more expensive, or only permitted for debtors that have solid credit (which would suggest you shouldn’t be worrying about their potential defaults in the first place). If your goal for using non-recourse is to protect yourself against non-payment, you need to determine if the higher cost is really worth the price. (Spoiler: It’s probably not.)
So when is non-recourse a good option? If you want to clean up your books. From an accounting perspective, certain forms of non-recourse factoring count as a “true sale” of the receivable. This means the receivable is removed from your balance sheet, and cash is added as an asset. In cases where you want to make your financials look better, this can be an effective solution.
The best way to avoid the headache of recourse is to avoid it altogether. If you incentivize your debtors to pay you on time, you can remove the issue entirely. And the best way to do that? Using our tools and analytics to offer intelligent, dynamic incentives. Try it out for free at Afox.
Questions? Shoot me a line at firstname.lastname@example.org