A factor or bank looking to make a loan on receivables is going to need the first position lien. They are going to require the receivable be free of any other encumbrances. Normally, setting up a factoring account is pretty straightforward. The contracts are signed, the factor files a UCC filing on the receivables, notices of assignment are sent to the customers and the funding begins. But if there’s already a lien on the receivables, then the factoring company can’t get its security interest in the receivables, and can’t fund your company until it gets resolved. This typically occurs when you already have a loan or other financing, or have back taxes owing. Instead of receiving funding immediately after the notices of assignment are sent, you will wait until it is sorted out.
A lien is a legal device secured creditors or tax authorities use to secure a priority claim on assets pledged for security. It’s how most business loans are secured, and the filings will state “all accounts,” or “accounts receivable,” or even “all assets.” Each filed lien has its own priority. The first one filed is the first priority lien. Subsequent filings are subordinate or junior liens. So, if a business uses accounts receivable to secure a business loan, and then takes out another one, those two filings will be first and second position liens, depending on which was filed first. This becomes important in the event of a default, as the senior debt has to be satisfied before any junior lienholders receive a payout. That is the general picture, at least.
A Subordination Agreement
Factoring companies will always require a first position lien on the underlying assets of a financing before they will buy invoices. At a minimum this should be a lien on accounts receivable. So if there is already a first-position lien on your assets, including accounts receivable, someone is already “secured” by those receivables. Put another way, if your company has gotten a secured loan that created a lien on your assets, your ability to factor invoices is hampered. But don’t throw in the towel just yet. You can fix this with a subordination agreement. It is part of an inter-creditor agreement between the two lenders. The subordinating party agrees to take a lower position, and allows the other party to take the higher one. This allows your factoring company to claim a priority lien position on the company’s accounts receivable, even though there is already a lien on those assets. In plain English, this means that the old creditor lets the new creditor jump in front of it in the payment queue.
The most common scenario is that you have business financing and you need to take a factoring line. Your existing lender is likely to be in the first position. In order for the factoring to happen, the existing lender has to subordinate. This is why it’s difficult to integrate existing loans with factoring.
However, before choosing to factor, think of why you need factoring while you already have a line of credit or MCA. There are two common reasons. First, your company has grown more rapidly than anticipated, and your current line is too small. If so, factoring may not be the right answer. In this case we recommend you replace your existing funding with a new financing solution.
Second, your company has hit some trouble and your business funds have been depleted. You hope that factoring will help you improve cash flow while management figures out what to do. This rarely works, and most lenders will consider your business over-leveraged. The balance sheet reflects that the company is operating at or beyond its credit capacity. Once the debt level is already excessive, adding another debt holder, like a factoring company, is the wrong approach. It’s better to seek the help of an expert to restructure your current lending situation.
Tax Liens
Another source of liens is federal and state taxing authorities filing liens for delinquent taxes. Tax liens typically apply to all assets and may have certain priority. Many business people do not realize that tax liens are a substantial barrier to obtaining financing. That’s why factoring companies request tax documents as part of their application. A lender will generally insist that tax issues be resolved before funding the company. Otherwise the lender’s lien would take a backseat to the taxing authority.
Hard to Get Another Lender to Subordinate
Why would someone subordinate? It’s hard to get another lender to subordinate. You have to convince the other lender that it’s over-collateralized, or that the subordination would benefit them. Over-collateralized means that the value of the collateral is much higher than the value of the loan. Essentially, the loan is safe for the lender, as there is a good chance that it can recover all its money if the company defaults. Lenders like that. It’s hard to convince them otherwise. Where’s the incentive to take a gamble and let a factor slip between them and the collateral?
One exception is some equipment lenders that file “all asset” liens despite the fact that the loan is secured by equipment. They are often willing to subordinate their position as to receivables and assets that have no relationship to the loan. In practice, the lender agrees to rank behind the factoring company on receivables and keeps its claim on the equipment.
The other option is to demonstrate that the subordination is in the lender’s best long-term interests. For example, the factoring line will help the company get bigger, thereby improving the lender’s position on its other collateral. Lenders rarely agree, as lenders want to see a well-collateralized loan.
In contrast, taxing authorities tend to be more receptive to this argument. Unlike a bank, they may be interested in subordination if the new debt will increase the company’s chance to pay in full. A taxing authority may subordinate if the company agrees to a payment plan. It may also insist that the factoring company make the monthly payments on behalf of the company out of the factoring advance or rebate. That way the factoring company is controlling the payment to the taxing authority, which knows the periodic payments will be made.
So the short answer is that a UCC lien on your receivables puts a factoring deal on hold until the lienholder subordinates. If that lender won’t budge and the debt itself is what’s holding you back, the better first step is to try to work out a deal with the existing lenders.
