Value vs Cost

It’s been quite a while since I posted here. Sorry...it’s been busy!

I’d like to share two brief stories today that build on my prior posts on the subject of opportunity cost and the broader question of financing smaller businesses.

Both of them illustrate the point that in many cases – far too many – business owners wind up doing damage to their businesses by thinking too narrowly about their financing alternatives.

I’ve explained in previous posts the issues that affect pricing in the spot factoring business. A couple of those, just as a refresher, are:

1) The factor has to assume that it’s possible that it will close only a single transaction with a client. So the dollar cost in terms of time and money invested in making the transaction can be quite high.

2) Transaction sizes are typically not very large, so the impact of high transaction costs is multiplied.

Because of the cost issue, the fee charged by a factoring company will necessarily have a higher component of cost-recapture than most financing transactions people are used to.

That’s the root of the “APR mistake”.

What’s the “APR mistake”?

It’s the assumption that converting a factor’s discount rate to an APR is a valid way to measure cost of money. And, more to the point, making bad business decisions on the basis of that assumption.

Thinking in terms of annual percentage rates makes sense when you are analyzing the cost of long term money. If not a 30-year home loan, then at least the duration of a normal car loan. It does not make sense when talking about a transaction whose duration is measured in days or weeks.

Thinking in APR terms makes sense when transactions are standardized and processing is streamlined. The origination and servicing costs on a per-transaction basis are a small part of the overall cost of funds. That’s not the case in a spot-factoring transaction.

So, what’s the “right” way to think about cost?

The right way is not to think about COST! It’s to think about VALUE!

The question is: what is the VALUE of the financing needed? Only if you can answer that question can you reasonably approach the question of cost. And the issue of VALUE can only be reasonably assessed in terms of opportunity.

Here are my two stories. They’re really not so much stories as they are data points, I suppose. Both come from my personal experience today—literally, on this Thursday November 4, 2010.

I’ve seen two spot factoring transactions today, one has closed and one is in process, in which the clients are much more sophisticated in financial terms than most small business owners.

One is a law firm doing business internationally with some big-name clients. The other is an accounting firm. If these guys don’t know how to evaluate financing costs I don’t know who does!

The law firm has been in business for over 25 years and is profitable. They have some clients that pay slowly, though, and they’ve maxed out their bank line. Rather than attempt to re-cast the bank debt in this environment they opted for a short-term solution to what they believe will be a short term cash need.

That solution is selling some high quality receivables. The APR, if they chose to look at the deal in that way, might seem quite high. But they recognize that the issue is not cost but value. And the factoring arrangement produces the result they need at the time they need it on terms they can live with.

The accountant has had a long and excellent professional career and is doing work for high quality business clients. But he’s only recently created his own specialty practice. He is owed a significant amount of money by good-credit clients but he can no longer fund his payroll out of his savings.

He went to his bank; the bank he has used personally for many years; and they wouldn’t even let him fill out a loan application. He hasn’t been in business long enough!

This person is very sophisticated financially. He researched all of the options that were open to him and he decided that a spot-factoring relationship was the best solution. He did NOT decide that on the basis of an annual percentage rate.

His decision was based on the VALUE of the financing to him, today; not on its cost.

I’m not saying that anyone should ignore cost. Nor am I saying that anyone should pay more than is prudent for financing.

But I AM saying this: the true cost of funds to a business owner is opportunity cost.

It is NOT the misused APR calculation that has kept many a business owner from making the best decision for his business.