How do intercreditor agreements set priority between a factor and an inventory lender?

Inventory financing and factoring often co-exist in the same working capital finance project. Both lenders are a little like a first cousin. Both lend based on the “working capital” of the business, so conflicts and overlapping collateral interest are common. Most situations are ironed out by what is called an intercreditor agreement. That is not the same as the standard intercreditor agreement between the factor and an equipment lender. If you own a business and have an inventory lender and a factor, the intercreditor agreement sets who has priority to what assets. The following discusses the unusual attributes of this particular agreement.

The Two Party’s Interests Collide

The inventory lender views the inventory as its number one collateral, the factor, of course, focuses on the accounts receivable. When the inventory is sold on credit the two party’s interests collide. When the inventory is sold the new account receivable springs into existence. The inventory lender typically claims priority in the receivable unless it is paid as part of the sale of the inventory. From your perspective if the inventory is sold on credit terms, both lenders can claim the same receivable. The line distinguishing what is collateral for one lender versus the other becomes blurry.

On the other hand the factor will typically offer to pay to the inventory lender any amount it owes its client. That helps to solve the problem to some extent. However most factoring arrangements are discretionary, and so the factor can reduce its exposure using those sums, and those amounts may not be as big as the inventory lender would like. For that reason the lender is reasonable to require more before subordinating.

Another working arrangement is the “buyout”. As each receivable is submitted to the factor the lender asks to get a partial pay down. The factor is allowed to choose to use amounts owed to its client to pay down the lender. If the factor does make the pay down it steps ahead of the lender in that particular receivable. If not, the lender retains its priority position. The devil is in the details and the facility is somewhat dependent upon how the inventory loan facility is structured. For you this means that each time an invoice is submitted to the factor that submission will determine which lender is ahead of the other on that invoice.

The first issue is the amount of the “buyout”. What the lender would like is the right to increase the buy out to up to 100% of the receivable amount. The factor wishes to impose an upper limit less than 100% of the receivable, which is tied to the lenders advance rate and some margin. Of course the factor wants to preserve “dry powder” for possible protective advances or shortfalls. The factor cannot utilize amounts paid out on buy outs for protective advances or shortfalls. If the buyouts can be for up to 100% of the amount of a receivable the amount the factor has available is small. The lender, for its part, argues that it wishes to receive the full value of a receivable created from the sale of its priority collateral before stepping aside. The factor also makes the argument that if there is a default the inventory lender can foreclose on the inventory and capture its full value. Typically this becomes a point of contention in the final negotiations.

All Assets Liens

The treatment of all other assets is also the subject of negotiation. Both the inventory lender and the factor typically take all assets liens in present and future assets. However the factor is anxious to have priority on receivable related assets, like books and records, related general intangibles, and bank accounts as relevant. These all go hand in hand with the receivables upon which the factor depends.

As for equipment and intellectual property rights, many intercreditor agreements provide for equal priorities and a pro rata share of recoveries. However, if the equipment is used in the production process, say to turn raw materials or work in process into the finished goods, or if the inventory is branded, the inventory lender may seek a priority or even a use period before its foreclosure. It becomes a subject for negotiation on a case by case basis. So if you make your own goods or sell a branded inventory it is something to be aware of.

Exclusive Enforcement Authority

As a general rule, the senior lender in any collateral class has exclusive or first right to enforce its rights. The inventory lender and the factor may have a potentially split priority position in the receivables. That raises the specter of a collection enforcement free-for-all where each party seeks to collect on the same account debtor. Imagine the chaos if the factor did not buy out and each party wants to collect on the same account debtor, providing contrary collection instructions. Accordingly, many intercreditor agreements, particularly those with the buyout provisions above, provide for exclusive enforcement authority of the factor as to all receivables notwithstanding priority position. This means your customers, the account debtors, will be provided instructions by just one collector, the factor, for all invoices.

In these circumstances the factor is obligated to turnover proceeds to the inventory lender on receivables to which the inventory lender has priority. Reciprocally the inventory lender will owe a turnover obligation if it collects on receivables where the factor has a priority position. Again, both parties see the advantage of the consistent message to the account debtor. For you this has practical implications, since the account debtor that receives notice is also one of your customers. Confusing notices create confusion with that customer.

The agreements needed for this type of facility are distinctively challenging. Successfully navigating the solution will depend on understanding and balancing competing interests. A well-thought and carefully drafted intercreditor agreement can minimize disputes and promote cooperation. If you have a factor and an inventory lender, the key is understanding which lender is ahead of the other on which asset. You should also understand the buyout and collection provisions well before the cash gets tight.