Ensuring that small and medium-sized enterprises (SMEs) have adequate access to finance has been a long-running problem for the UK economy. In recent years, however, this problem has become more acute. SMEs tend to rely heavily on bank loans and overdrafts for external short and long-term finance. Following the credit crisis, this source of finance has become less plentiful. Banks are now more risk averse and are more focused on rebuilding their capital base. As a result, SMEs find it difficult to raise finance from their traditional lenders. Bank loan rejection rates are the highest in Europe and have recently been higher than their historical norm. (1) In addition, the cost and delays associated with raising bank finance have risen.
The financing problems of SMEs have been made worse by large businesses extending the credit periods taken to pay suppliers. For some SMEs, this has helped to create a ‘perfect storm’. The UK government is aware of the problems facing SMEs and has recognised the need for alternative sources of finance to help relieve the pressures. In this article we explore one new source of financing –auction-based invoice financing – which is designed to meet their cash flow and working capital needs. Although still in its early days, it has attracted considerable interest.
Before considering this new form of financing it may be a good idea to outline the main features of debt factoring and invoice discounting. You may recall that both of these well-established sources of finance use the trade receivables of a business as asset-backed security for loan finance. A debt factor performs two main functions for a client business: the administration of credit sales, and the provision of working capital finance. The first function involves recording credit sales, invoicing customers and chasing overdue accounts. This can be a valuable service, particularly for growing businesses where key managers can be released to focus on tasks of potentially greater benefit to the business. The second function involves advancing to the business 80%, or more, of the value of trade receivables accepted. These receivables are used as security for the advance and, when credit customers finally pay, the amounts received are used to repay the advance. Where a credit customer fails to pay, the precise form of agreement between the factor and the client business will determine which party incurs the loss.
A debt factoring agreement can be of great benefit to a business requiring regular injections of working capital. However, it does involve a long-term commitment and can be quite expensive compared to other forms of short-term finance. Furthermore, businesses often prefer to keep control of all aspects of their relationship with their customers. Where a third party collects outstanding credit sales, there is always a risk that harsh or inflexible methods will be used that succeed in upsetting customers. Very small businesses normally find the cost of setting up a factoring agreement prohibitive and businesses in industries where trade disputes are common will find that they are unable to secure the services of a factor.
Invoice discounting is also a form short-term financing where the trade receivables are used as security and, once again, amounts advanced are normally 80%, or more, of the trade receivables accepted. However, the invoice discounter does not administer the credit sales of a business and the agreement between the invoice discounter and the client business can be for a shorter term. The amounts advanced must be repaid irrespective of whether the trade receivables pay the amounts due. There is no agreement that the invoice discounter will bear losses arising from customers defaulting. Invoice discounting is normally cheaper than debt factoring, largely because there is no agreement to administer credit sales.
Figure 1 below reveals the popularity of the two methods of financing over the five-year period 2008–2012.
Figure 1. Client sales volumes: Domestic factoring and invoice discounting 2008–2012
We can see from the figure that invoice discounting is, by far, the more popular source of finance. Domestic factoring has still not returned to pre-credit crisis levels and rose by only 1% in 2012 when compared to the previous year. Invoice discounting, on the other hand, has bounced back and now exceeds pre-credit crisis levels. It increased by 6% during 2012.
A government report recently argued that demand for trade receivables based finance among SMEs could be increased in two ways. The first is to eradicate the still widely-held belief that it is a sign that a business is in a weak financial position and has no other financing options available. The second is through innovation and the application of on-line technology. (2) It is this second way to which we now turn.
This new form of financing originated in the US but has been pioneered in the UK by operators such as Market Invoice and Platform Black. They offer an online platform where finance providers bid to advance money to SMEs based on trade receivables’ invoices issued. The finance providers that make these advances are largely made up of institutional investors, such as hedge funds and asset managers, and wealthy individuals. However, since August 2013, the UK government has also provided finance for this new market.
Market Invoice, which was launched in early 2011, sets out the auction process on its website. In this section we will briefly go through this process using a simple example. Let us assume that a business, which has a turnover of more than £10m, issues a trade receivables invoice for, say, £45,000 to a credit customer and then decides to raise finance on the strength of it. When using the Market Invoice platform, the following steps are involved:
The business, posts the invoice and all relevant documentation (purchase orders and so on) on the Market Invoice website. In addition, acceptable thresholds need to be set for the following:
A ‘buy now’ option can also be set, which sets out the business’s preferred level of advance and finance fee. This option is similar to the ‘buy now’ option available on eBay. Let us assume that the business sets the following preferred, or ‘buy now’, options:
Note that an advance of 90% of the invoice value is normally the maximum available.
The auction begins. If a finance provider exercises the ‘buy now’ option, the auction is automatically closed and other bids will be deemed to have failed. If the ‘buy-now’ option is not exercised, presumably because it is too ambitious, the auction will run its course. At the end of the day, the bid that comes closest to the ‘buy now’ option will then be declared the winner.
Let us say that the winning bid offers 80% of the invoice value at 1.0% per 30 days. The business will then receive £36,000 (80% x £45,000) within 24 hours of the auction closing.
When the credit customer pays the amount due, it is paid into a client account of Market Invoice. If the full amount is paid after 30 days, it is then allocated as follows:
This represents a gross return, when annualised, of about 12% for the finance provider. However, a fee of 20% of the profit must be paid over to Market Invoice for the use of its platform.
A fee is charged by Market Invoice to the SME for use of the platform, which varies according to usage and business size. The average fee payable is 1.9% for SMEs with a turnover of £250,000 and 0.5% for those with a turnover of £10m.
Where the credit customer pays after more than 30 days, the fee payable is increased to the finance provider and so the business will receive correspondingly less. The finance fee due in the example provided is £450 (1.0% x £45,000) which, over a 30-day period, works out to £15 per day. If, however, the credit customer pays after 40 days a further 10 days at £15 per day is payable. The total fee payable will, therefore, be 40 x £15 = £600.
Platform Black began operating its auction platform in June 2012. Its website states that the auction period is normally one, two or three days with fixed borrowing periods of 30, 60 and 90 days (although early repayment is possible). Transaction fees for each borrowing period are 0.5%, 0.75% and 0.9% respectively, subject to a minimum fee. (4) Finance providers can bid for only part of part of the auctioned invoice, thereby allowing them to spread their funds more easily and to reduce risk. This also helps to increase the degree of competition in the bidding process.
Both Market Invoice and Platform Black claim that, as at the end of September 2013, all SMEs using their auctions have succeeded in raising the finance required. On average, those using the Market Invoice platform auction invoices eight times per year. (5)
Various benefits are claimed for this form of finance. From the businesses’ perspective, it is relatively easy to set up and can normally be done within a few weeks. It can often be carried out online without the need for site visits, lengthy meetings or much form filling. This type of financing also offers the businesses a great deal of flexibility and control over its operations. It is up to a particular business to decide the extent to which it uses the service. The timing, amount and nature of the invoices ‘sold’ through the auction process are entirely within its discretion. In contrast to many factoring and invoice discounting agreements, businesses are not tied down by exclusivity agreements. There are also no requirements for personal guarantees or for the SME to issue debentures to secure the finance needed. The auction process means that businesses are not dependent on a single finance provider. By having access to many providers, the risk that access to finance will suddenly be withdrawn is reduced.
This type of financing shares some of the same benefits of traditional factoring and invoice discounting. It offers a ‘spontaneous’ source of finance to businesses, which means that, as revenue increases, so does the availability of finance for working capital. It is also a confidential service (like invoice discounting but unlike factoring) and there is no need for customers to know that the service is being used.
Auction-based finance tends to be cheaper than traditional factoring agreements for two reasons. The first is that the fees for using the service consist only of a transaction fee payable to the auction operator and a finance fee payable to the lender. SMEs are not required to pay annual fees or to pay fees for setting up or terminating the service. The second reason is that competition among finance providers for the auctioned invoices helps to bring down the financing fees. Platform Black, for example, states that between 20 and 80 bids are typically made for an auctioned invoice. (6)
Not all SMEs, however, can avail themselves of this type of finance. It is only for those that sell to other businesses rather than for those that sell to the public. Moreover, invoices auctioned are normally those issued to large businesses, which means that SMEs that do not sell to their ‘blue-chip’ brethren are excluded. For those that do, however, it means that SMEs with only a short trading history (six months in the case of Market Invoice) can still use the service. This is because the main financial risk is associated with the ‘blue chip’ customer rather than the SME issuing the invoice. The cost of finance for the SME using this method, however, is not certain and will vary from invoice to invoice according to the perceived level of risk and the availability of funds. Where the customer does not pay the amount owed, the SME remains liable for the advance received and so must repay the lender.
Invoices for very small amounts are not normally traded. Platform Black, for example, tends to auction invoices in the £5,000 to £500,000 with an average invoice size is £40,000. (6) There is no minimum size criterion for SMEs using Platform Black but Market invoice states that it only works with SMEs with an annual turnover of at least £250,000. (7)
From the perspective of finance providers’, rates of return are claimed to be around 12–15% (8). This appears very attractive when compared with, say, investing in loan stock. There are likely to be fallow periods during a year, however, when providers of finance fail in their bids or feel there are no suitable investment opportunities. The returns quoted are before taking account of the risk that the customer will not pay and that the SME then defaults on repayment. So far, default rates have tended to be low, which is, perhaps, not surprising given the ‘blue chip’ nature of the customers. Platform Black, for example, quotes an extremely low default rate of 0.12%. (6)
The main risk of default is likely to be through trade disputes between the SME and the customer. It is interesting that Platform Black sees SMEs in the construction industry as potential users of the auction process, even though their industry is notorious for trade disputes. For these SMEs, the supporting documentation provided, such as quantity surveyors’ certificates or written confirmation that the customer is willing to pay, will need to be very convincing.
While the market for this form of finance is growing rapidly it is still in its infancy. Towards the end of September 2013, for example, Market Invoice auctions had succeeded in advancing a total of £72m to SMEs (9) since operations began and Platform Black, which began at a later date, had advanced £25m. (6). Both operators are currently auctioning invoices valued at around £5m per month. We can see from Figure 1 above that these amounts represents a drop in the ocean compared with amounts advanced by traditional factors and invoice discounters.
To achieve a real break though there are still difficulties to overcome. Many SMEs that already use invoice based financing are locked into long-term agreements with financial institutions and so it may be some time before they are free to use invoice auctions. In the short-term it is therefore important to create a market among those SMEs that are new to invoice-based finance. This means, not only raising awareness of the availability of this form of finance but also overcoming the kind of prejudice described in the introduction. Invoice-based financing must be seen as a perfectly legitimate alternative to bank lending rather than a sign that something has gone wrong. There are signs that a market is being created. Market Invoice, for example, claims that 75% of SMEs using their platform are new to asset-backed financing methods. (5)
This new financial market remains unregulated, which adds to the perceived risks involved. The main auction platforms are, however, aware of the need to inspire greater confidence among SMEs and finance providers. This means the creation of relevant rules and codes of conduct or joining existing finance associations with such rules and codes. Platform Black, for example, is a member of the Asset Based Finance Association.
Auction-based invoice finance has generated considerable interest within the finance industry and it is easy to see why. The potential for SMEs to have greater flexibility and control over their trade receivables and to be able to access finance at reasonable cost represents a real challenge to traditional providers of asset-backed finance. Furthermore, by creating a more diverse range of financing options, it offers the UK economy the potential to develop a more robust financial system. The recent credit crisis cruelly exposed the dependency on SMEs on bank finance and its consequences.
Auction-based invoice finance is already helping to fill the finance gap created by the withdrawal of bank finance, however, the market is still very small. It will take time to raise awareness among SMEs concerning this new kind of finance and to overcome the negative perceptions that are generally held concerning invoice-based finance. It will also take time for those SMEs locked into agreements with traditional factoring houses and invoice discounters to be in a position to exploit this opportunity. To help boost confidence in this new financial market, the government could play a useful role by subjecting it to regulatory oversight.
Written by a member of the Paper F9 examining team