Factoring enjoys a long and storied history dating to 1780 BCE and the Code of Hammurabi. For as long as there has been trade and commerce, there has been a need for some form of flexible access to funds both for the supplier of goods and services as well as the purchaser. As civilizations became more complex and the scope of available goods and services expanded, the options for financing also evolved. But factoring remained as one of the purest forms of obtaining and managing cash flow for a new or maturing business. It was just a matter of time before another type of factoring took the world by storm in the form of the credit card.
By definition factoring is a means of securing financing in which the borrowing company surrenders ownership of its trade debt to the lender in exchange for immediate access to the amount of the debt, minus a discount. When Babylon's great ruler Hammurabi compiled a code of laws governing all aspects of Babylonian society, he included 26 laws specifically addressing commerce and trade. Lending principals such as acceptable collateral (crops, slaves and children qualified), method of repayment, the duration of a loan and the maximum amount of interest (33 ½ % on loans for grain, 28 ½% on loans for silver) were firmly established. Later, Roman merchants used agents to guarantee trade credits and were the first to issue promissory notes at a discount. These agents became known as "factors", derived from the Latin word meaning "doer or maker" and from the French word "facteur" meaning "agent or representative".
The roots of modern factoring are closely related to the development of merchant banks. In the Middle Ages, circa 1300-1400 AD, usuary laws were passed in many parts of Western Europe. These laws prohibited Christians from charging excessive fees for the use of monies. Higher risk loans deserving of higher rates of interest were made by Jewish merchant agents who were not culturally bound by the usuary laws. For instance, the rights to sell a farmer's grain at harvest were exchanged for a cash advance from these merchant agents during the planting season. In addition, the Jewish agent performed several other services. He provided the financing (and credit services) as well as underwriting (and insuring) the shipments. He would loan the grain farmer money to plant and grow the grain, he would insure the delivery of the grain to the merchant wholesaler and he would arrange for other sources of the grain should there be a crop failure that season. These merchant bankers eventually began buying and trading in the grain debt instead of the crop itself, becoming the precursors of modern merchant and investment banks.
By the 1500's AD, Colonial America was accustomed to using merchant agents in Europe to finance shipments of raw materials such as fur, timber, tobacco and cotton overseas. The European merchant bankers would also factor any shipments made to the colonists. Sellers on either shore were paid a discounted amount of the invoice due from the purchaser before goods were shipped and the factor would take a percentage for collecting the money owed to the seller. Until the early 1700, both English and American law forbade the selling of invoices unless the purchaser, or debtor, was notified in advance. Eventually US state governments adopted a rule that the debtor did not have to be notified, giving rise to non-notification factoring.
As the early factors moved away from taking possession of goods in addition to financing and insuring the credit, and as the Industrial Revolution swept across Europe and America, the creditworthiness of the customers (the debtors) became the focus. Factors would primarily guarantee payment from the approved customers without recourse to the invoice seller. Thus, non-recourse factoring became commonplace and remains an often-used form of factoring.
However, in the 1800's, particularly in the antebellum South, so-called "cotton factors" still performed a myriad of services, including selling the crops, purchasing goods and even handling shipment of the goods for the cotton planters. Similar services were performed by factors for other commodities such as sugar cane and molasses. At times, even the purchase or selling of slaves or the placing of planters' children in distant schools were handled by these "one-stop shop" factors.
With the explosion of the textile and garment industry in the early 1900's, factoring became the pre-eminent form of financing. Traditional banks, primarily small local banks, were limited by law as to how much they could advance to any one business. Factors were much less restrictive and soon other industries, such as transportation and freight forwarding, were led to rely on factors for cash flow enhancement. To this day, these industries choose to factor their invoices for the ease and flexibility. After World War II, any business that invoiced other companies was a good prospect for the cash advances and credit services offered by factors. Smaller rapidly growing firms selling to creditworthy large companies found it easier to secure an accounts receivable arrangement than to obtain a traditional loan.
Around the same time, the retail furniture, garment and textile industries realized a new need to extend credit to their customers, the people buying their products. Many customers simply did not have the cash to purchase large-ticket items. Earlier, in the 18th century, the idea that consumers could pay for furniture or clothes in small weekly payments gave rise to the "tallymen". They kept a tally of what people bought on a wooden stick, one side marked with notches representing the debt and the other side was a record of the payments made. In 1730, Christopher Thorton, a furniture maker, offered furniture that could be paid off weekly. Further borrowing from the tallyman concept, in 1914, Western Union gave their best customers a metal card that allowed them to defer payments, interest free, on services used. This system became known as "metal money" and ten years later, General Petroleum issued their own metal card to employees and select customers and, later, to the general public. In the late 1930's, American Telephone and Telegraph introduced their "Bell System Credit Card" and soon railroads and airlines followed suit. During World War II, the use of credit cards was prohibited but as commerce began to boom after the war, the demand for credit cards increased. The Latin word for credit, "credere", means "to trust, entrust, believe" and merchants believed credit cards could improve business.
By the start of the 1950's, the "buy now, pay later" attitude really took hold. The first "plastic money", a plastic credit card that replaced the old metal card, was issued by Diner's Club Inc. in 1951. Unlike previous cards that could only be used for goods or services offered by the issuer of the card, the Diner's Club card could be used at a variety of stores and businesses. Card users enjoyed having up to 60 days to pay in full and the businesses accepting the card enjoyed the increased sales.
The mechanics of how credit cards work mirrors the mechanics of factoring. The credit card issuer approves the creditworthiness of the card applicant. When the merchant accepts the card, the credit card issuer immediately advances to the merchant the amount of the sale, minus a discount (typically two to four percent) of the purchase price. The card issuer then collects the debt from the card holder at a later date. Just as in factoring, funds are advanced to the merchant, net of a discount while the creditworthiness of the buyer is guaranteed by the credit card company. The seller benefits from being able to sell more product by extending credit to his customers without responsibility for collecting the debt.
Banks immediately saw the potential in issuing their own credit cards. Franklin National Bank in New York began issuing credit cards in 1951 and many small independent banks did likewise. The first revolving credit card was issued by Bank of America in California. The BankAmericard offered payment options to the cardholder, where they could pay in full or make monthly payments while the bank charged interest on the balances. In 1965, Bank of America began issuing license agreements to other banks nationwide, allowing the other banks to issue BankAmericards. In 1967, a California association of banks introduced the MasterCharge program and by 1970 most independent banks had converted to either BankAmericard or MasterCharge. As the credit card industry went international, the BankAmericard became VISA and MasterCharge became MasterCard.
Factoring also took off in the 1970's and 1980's as interest rates soared and traditional banks tightened credit for commercial lending. Private factoring companies sprang up, some specializing in certain industries or offering specialized services such as payroll processing. The widespread use of computers greatly simplified the accounting aspect of factoring and the internet and worldwide web made the exchange of information fast and efficient. But the key services that factors provide their clients remained the same: credit analysis of current and prospective customers, funds advanced on purchased accounts receivables, maintaining the A/R ledger and managing collections. The outsourcing of these services to a factor help to insulate the business from potential credit risks and liquidity issues and reduces the need to hire permanent staff.
The nuances of factoring have changed through the centuries, adjusting to the needs of the times. With the advent of credit cards, the concept of factoring is familiar to businesses and consumers alike. Whether a start-up company, a Fortune 500 business or a buyer of goods and services, the evolution of factoring has had a profound effect on the world of finance.