Suppose you are running a business in need of a loan. There are various ways you might obtain one, but in countries with well-developed financial infrastructure, one of the best ways is to borrow from a bank.
Banks conduct financial due diligence on a company before they are willing to loan them money. Depending on what they find, the bank may charge a lower or higher interest rate. Sometimes they will deny the company’s application all together. This can happen for all kinds of reasons, even if the company applying for the loan appears to have no immediate risk of bankruptcy.
Companies denied a traditional bank loan will often look into alternative forms of financing. For those with unpaid invoices on the books, one of the best options is invoice factoring.
Invoice factoring allows a company to sell unpaid customer invoices to receive cash in advance. The lender usually pays 70-80% of the value of the invoice up front, and the remaining value (minus a fee) once the customer has paid. This fills a key niche in the lending ecosystem because it provides very fast, accessible liquidity for companies, particularly those who have trouble acquiring more traditional loans. For this reason, the US invoice factoring industry is expected to reach about $9 billion by 2025.
Invoice factoring can be further broken down into two categories:
In this arrangement, the company takes responsibility if the customer does not pay the invoice within a specified time period (usually 60-90 days). Recourse loans are generally cheaper, since the factoring company doesn’t need any information about the customer’s creditworthiness to make the loan, reducing the need for expensive credit checks.
In this arrangement, the lender agrees to take a loss if the customer fails to pay its bills. Recourse loans are generally 40-80% more expensive than non-recourse loans. Because of the great expense and narrow benefits, non-recourse loans are the less popular option for invoice factoring.
Why is invoice factoring so much more expensive than a traditional bank loan?
When loans have high interest rates, it’s usually caused by one of two things:
- High overhead costs for issuing or managing the loan
- The lender’s belief that the borrower may not pay back the loan
Both of these are an issue for invoice factoring. To reduce the risk of borrowers defaulting, factoring companies conduct due diligence on both the borrower and the customer whose invoices they are purchasing. Increasing due diligence ideally decreases the risk of default, but it raises overhead for the loan.
So for every loan, there is a tradeoff between due diligence and loan cost. In practice, a significant portion of the due diligence involves sending non-standardized PDFs of financial statements back and forth via email and entering values on those PDFs into another database. All of this takes a lot of time and labor, which is one of the chief reasons invoice factoring carries such high interest rates. There is also another important reason to conduct due diligence: fraud.
Factoring fraud and the story of ‘Mr. S’
Like other forms of alternative financing, the factoring industry must deal with a high incidence of fraud. The most common type of fraud is falsified invoices created by companies that are in financial trouble. The typical story goes something like this:
Mr. S ran a barely profitable trucking transport company that suffered from cash flow problems. The industry is known for long periods for payment, and the company had to regularly wait 90 days to have invoices paid.
Mr. S entered into a factoring arrangement to generate cash flow. The factoring company played no role in collecting debts, allowing the customer to collect the money and report on a monthly basis. The debtors paid the company as usual. At the end of each month the company factored new invoices and reported the collections and new factoring to the factoring company. It offset the two amounts and paid or collected the balance. This system of reports and offset payments worked fine for many months and the relationship between the parties became stronger.
One day a truck broke down and the company needed $40,000 to repair it, but the company did not have the money. Mr. S created a false invoice to one of its regular customers for $50,000 and this invoice was added to the list of invoices for factoring. The factoring company paid 80% of the invoice (the required $40,000) under the terms of the factoring agreement and the money was used to fix the truck.
Later the company needed the money that should have been collected from the false invoice. It still did not have the money, so Mr. S created another false invoice and factored it. The money from the second invoice was offset against the money owed from the first invoice. The records showed that the first invoice was collected and the required money paid to the factoring company. The company had bought some time.
That seemed all too easy. Mr. S decided that he wanted a new car, so he created another fictitious invoice and factored it. He now had the money for the new car and, if the system stayed in place, would never have to actually pay for it. More false invoices were created from both real and fictitious customers in ever increasing amounts to cover the factoring costs. The factoring company saw the increase in the business and noted that all these invoices were paid on time. The company appeared to be a good customer, and invoices were factored more readily at better rates.
The scheme was found when the factoring company decided to randomly audit the ledger that it had factored and discovered that a number of the invoices were not real. By the time that the fraud was discovered, there were more fictitious invoices factored than real ones.
Customers like Mr. S drive down profitability for factoring companies and drive up prices for its customers. The type of fraud where a company pays back an old loan by taking out a new one is called a “lapping scheme,” and is far too common in the factoring business because factoring companies don’t have a great way of checking the authenticity of invoices.
Random audits can catch such frauds, but by the time they do the outstanding debt has often grown substantially, and the factoring company will take a large hit to its earnings when this fraud is discovered. Conducting audits on all borrowers the traditional way is too expensive for many factoring companies to afford, which is why this type of fraud continues to happen.
How blockchain can make invoice factoring cheaper, faster, and more convenient
Blockchain can improve the tradeoff between high overhead and high risk of default or fraud. The key innovation is blockchain’s ability to automate a significant portion of the underwriting process by connecting data systems that were previously disconnected.
There are many different parties involved in making a loan — the factoring company, the underwriter, the back office at the borrower’s company, the company that conducts credit checks, and many others. Each of these entities has their own system of databases and data storage formats. Currently, communication is facilitated by back-office staff sending emails with PDFs attached. Data in these PDFs can be faked, and catching such falsifications often requires expensive manual audits.
Blockchain provides a single unified data layer to connect all of these systems via software. Instead of back-office staff manually entering data into their company’s database, each data system can read from and write to the blockchain via an API.
Transactions made via blockchain generate payment histories, which can be securely shared with lenders and credit tracking companies. Basic information about a company can be collected as part of the onboarding process. This information can be sent directly to a factoring company if a company wishes to apply for a loan.
With all this important data written automatically and securely to the blockchain, loan overhead can be significantly reduced.
VeriFactor: Our blockchain-based lending product
All of the benefits previously mentioned are available through our lending product VeriFactor, which runs on our blockchain platform STRATO Mercata. The benefits of blockchain allow VeriFactor, to offer 24 hour turnaround times for invoice factoring and some of the lowest rates in the industry.
How low? Well we expect to be able to offer invoice factoring for 6.2-23% APR depending on the creditworthiness of the borrower and a number of other metrics. For a 30-day loan, this works out to a factoring fee of 0.5-1.75%.
VeriFactor will also offer spot factoring, allowing much more flexibility for borrowers. But beyond all these benefits, borrowers on STRATO Mercata will have access to a pool of factoring companies and the ability to pick the best deal among those offered. We expect this competition to drive down rates for customers, while simultaneously pulling in new customers who will be attracted by the lower rates.
If you’re interested in experiencing the benefits of the invoice factoring on blockchain for yourself, you can contact sales to learn more.