What is a Forward Flow Agreement?

A forward flow agreement, also known as a forward flow facility, is a type of financing arrangement that allows a company to sell its future accounts receivables to an investor in exchange for upfront capital. This provides the company with immediate access to capital based on the value of its future invoices.

In a forward flow agreement, the company sells a certain percentage of its future invoices to the investor at a discount. This allows the investor to earn a return by collecting the full face value of the invoices when they come due. Meanwhile, the company gets immediate cash to fund operations without taking on debt.

Elements of a Forward Flow Facility

There are several key elements and terms involved in setting up a forward flow agreement:

Advance Rate

The percentage of each invoice’s face value that the investor will pay upfront to the company. Typical advance rates range from 70-90%.

Discount Rate

The rate of interest charged by the investor on the advanced funds. Usually benchmarked to a rate like prime or LIBOR.

Facility Limit

The maximum amount the investor will advance over the course of the agreement. Usually a percentage of the company’s average monthly sales.

Tenor

The length of the agreement. Typically 6 months to 3 years. Can be revolving.

Concentration Limits

Caps on the percentage of invoices from any single customer that can be sold. Usually 5-20% of the total purchase.

Eligible Receivables

Requirements defining which of the company’s AR can be sold. Based on credit quality, age, concentration, etc.

Fees

In addition to the discount rate, there are often flat monthly fees and early termination fees.

Reporting Requirements

Requirements for the company to share sales reports, AR aging reports, compliance certificates, etc.

Advance Process

Here is an overview of the process to receive an advance once a forward flow agreement is in place:

Company completes a sale to a customer and issues an invoice
Company uploads invoice data to the investor’s online portal
Investor verifies the invoice meets eligibility criteria
Investor advances agreed percentage (advance rate) of the invoice value, less fees
When customer pays the invoice, investor collects the full payment
Investor returns any remaining balance, less fees, to the company

The process from invoice issuance to funding typically takes a few business days. Funding may be every week, every two weeks, or monthly depending on terms.

Benefits of Forward Flow Agreements

There are several potential benefits that make forward flow facilities attractive to companies:

Immediate Access to Capital – Provides quick influx of cash without waiting for invoice payments
Improved Cash Flow – Smoothes out uneven cash flows from AR and invoices
Off-Balance Sheet – Structure keeps facility off the balance sheet as a debt item
Cheaper than Factoring – Discount rates are typically lower than invoice factoring rates
Recourse Only on Unsold AR – Company only pays back advances on invoices it never sold
Retain Ownership of AR – Company still owns the accounts receivable
Credit Line Not Required – Does not require or impact corporate credit lines

Additionally, rates may improve over time as the investor becomes more comfortable with the risk of the company’s receivables.

Use of Funds

Forward flow agreements provide very flexible working capital since the advances are not tied to a specific use of funds. Typical uses include:

Funding day-to-day operations Hiring personnel Purchasing inventory and materials Investing in equipment upgrades Expanding marketing campaigns Entering new markets Funding new product development

Essentially, the capital can be deployed wherever it is needed most to grow the business.

Costs and Fees

There are a variety of fees associated with a forward flow facility. It’s important to take all costs into consideration when evaluating an offer. Common fees include:

Discount Fee – Usually LIBOR/prime plus a spread of 2-15%, annualized
Servicing Fee – Up to 2% of the purchased invoice value
Underwriting Fees – Ranges from $3,000 to $50,000+ Legal Fees – Vary based on amount of negotiation required
Early Termination Fee – Up to 5% if cancelled before maturity
UCC Filing Fees – To secure interest in the receivables
Miscellaneous Fees – Compliance, reporting, wire transfer fees

The all-in cost of the facility needs to be analyzed relative to other financing options the company has available.

Eligibility of Receivables

In order to mitigate risk, investors have strict eligibility requirements governing which invoices they will agree to purchase:

Credit Quality – Strong credit profile of customers
Concentration Limits – Caps exposure to any single customer
Cross-Aging Terms – Exclude severely past due accounts
Days Sales Outstanding – Often less than 90 days from invoice date
Seasoning Periods – Only invoices issued after facility activation
Excluded Industries – Some industries deemed too high risk
Foreign Receivables – Domestic companies usually preferred

Meeting eligibility criteria ensures the receivables align with the investor’s expected yield and default models.

Analyzing Forward Flow Economics

In order to determine if a forward flow agreement makes sense, companies should analyze the economic tradeoffs relative to alternative forms of financing. Important factors to model out include:

Total Cost of Capital – The all-in discount rates and fees
Account Receivable Metrics – Days sales outstanding, dilution, yields
Required vs. Optional Amounts – Commitment fees for non-mandatory amounts
Payment Frequency – Can capital be pulled more or less often?
Term Length – Longer tenors may have better pricing
Flexibility – Are there restrictions limiting operational flexibility?

Running scenarios around retention percentage, turns per year, and implied APR can give key insights into the true cost. Thoroughly projecting the P&L impact is crucial.

Tax Implications

There can also be tax considerations to evaluate when monetizing future receivables:

Revenue Recognition – Gain may need to be amortized over term instead of upfront
Accounting Treatment – Requires balance sheet reclassification
Taxable Income Issues – Timing differences on recognizing discount fees
Sales Tax Obligations – Vary by state and structure of agreement
Transfer of Assets – Gain or loss on sale of assets

Consulting the company’s accounting and tax advisors is highly recommended.

Structuring Details

Forward flow agreements involve complex legal structuring given the sale of future assets. Here are some key structuring considerations:

True Sale vs. Secured Loan – True sale draws clearer line on transferred assets
Parent vs. Subsidiary as Seller – Corporate structural questions Domestic vs. Offshore
Special Purpose Vehicle – SPE implications
Solvency and Fraudulent Conveyance – Require solvency opinion
First Priority Lien – Right to liquidate serves as collateral
Representations and Warranties – Confirms eligibility of assets
Recourse vs Non-Recourse – Extent funders can recover from seller

The contract terms matter greatly in an event of default such as bankruptcy. Companies should fully understand potential outcomes before signing.

Accounting Treatment

The specific accounting of forward flow agreements under U.S. GAAP or IFRS is very nuanced. From the seller perspective, key considerations include:

Sale vs. Secured Borrowing – Debt vs. revenue recognition
Consolidate SPE – Off-balance sheet treatment if no control
Asset Purchase vs. Collateral Transfer – True sale analysis
Yield Method Revenue Recognition – Timing tied to underlying receivables
Discount Rate as Interest Expense – Amortize over facilities term
Ongoing Costs – Debt issuance and servicing expenses

Application of standards like ASC 860 and IFRS 9 dictate balance sheet presentation and impacts the income statement.

Due Diligence Required

Given that forward flow facilities represent an outright sale of invoices, investors conduct very rigorous due diligence before approving a facility including:

Historical Data – 12-24 months to analyze trends
Portfolio Performance – to determine potential future losses
Aged Accounts Receivable – Identify past collectability issues
Customer Concentrations – Review the largest subset of invoices
DSO Metrics – Evaluate historical days sales outstanding
Billing Terms – Standard payment terms with customers
Credit Policies – Review approval, collections processes
Sales Contracts – Spot check underlying deals
Financial Statements – 3 years to assess performance (or whatever’s available)
Interviews – Discuss protections against fraud

This due diligence allows investors to gain comfort extending millions of dollars against unpredictable future sales.

Steps to Securing Forward Flow Financing

If a forward flow facility seems potentially suitable, here are key steps the company should take to pursue one:

Analyze historical sales and accounts receivable data
Review eligibility criteria from prospective financiers
Evaluate economics under different scenarios
Consult accounting advisor on proposed structure
Partner with a financing broker to interface with funders
Prepare due diligence documents for review
Negotiate key facility terms
Obtain board approval of final agreement
Close, fund facility and conduct ongoing reporting

Having your internal records in order and leveraging an advisor to interface with capital providers simplifies the process while still protecting the company’s interests.

Pros and Cons

Some key benefits and drawbacks to weigh:

Pros:

Immediate capital for growth goals
Maintain ownership of customers
Cheaper financing than some alternatives
Off-balance sheet treatment possible
Payback tied directly to payments

Cons:

Higher total financing costs
Can be dilutive to margins
Rigid eligibility requirements
Significant reporting needs
No control over advance timing

The pros and cons balance depends greatly on the specific business model and capital structure. The cost of forward flows should be compared to alternative facilities.

Recourse Factor Provisions

One specialized type of forward flow arrangement that limits a company’s financial risk is called a recourse factor provision. Under this structure:

Company and funder establish concentration limits per customer
Funder advances on all invoices up to limit
If any invoice from customer defaults, company owes amount advanced on that specific invoice above limit
Company has no obligation beyond specific defaulted invoice amounts

This protects the company by capping exposure to only a set level of advances per client. It incentivizes proper underwriting by the funder across their entire purchased portfolio.

Evaluation Process

Given the complexities and importance of properly structuring facilities, funders follow a highly standardized process including these key milestones:

Initial Screen – High level review of eligibility
Application – Gather data for detailed underwriting
Underwriting – Forecast expected yield based on risk
Term Sheet Issued – Propose high-level terms
Management Call – Discuss structure, controls
Documentation Finalized – Extensive multi-week negotiations
Board Approval – Review final contracts pre-close
Closing & Funding – Activate purchase of new invoices

This standardized funnel allows investors to systematically filter opportunities to ensure those ultimately approved meet their investment return hurdles.

Forward Flow in Fintech

Financial technology innovations are rapidly changing the forward flow industry. Key innovations include:

Online Platforms – Streamlining origination and portfolio management
Automation – Using machine learning for document analysis and funding
Alternative Data – Expanding approval criteria with expanded datasets
Embedded Finance – Forward flow APIs integrating with normal software
Blockchain – Cryptographic innovations improving transparency

These trends will likely accelerate adoption while also compressing margins over the long-run. But in the near-term, technology provides a tailwind for the industry and companies utilizing these tools.

Comparison to Factoring

Forward flows have some high-level similarities but major differences from traditional invoice factoring which include:

Advances – Both provide upfront funding against unpaid invoices
Discount Rates – Forward flows usually have lower financing costs
Recourse – Factors offer non-recourse options rarely seen in forward flows
Term Length – Forward flows support longer 6-36 month deployments
Ongoing Fees – Forward flows have added servicing charges
Eligibility – Forward flows have more constraints on eligible assets
Flexibility – Factoring aligns better with fluctuating sales volumes

So while factors provide fairly standardized products, forward flows give more control over deal terms but less volume adaptability.

Reporting Compliance

In order to track ongoing eligibility and signals around customer credit, forward flow agreements include extensive reporting requirements requiring companies to provide:

Periodic Borrowing Base Certificates – Validates eligible collateral
Accounts Receivable Aging Reports – Screens for past due invoices
Concentration Reports – Details largest customers
Payment Reports – Internal visibility into customer payments
Compliance Certificates – Contractual representations on compliance
Notice of Material Changes – Prompt alerts around key risk metrics
Audits – External verification and audits of records

While most data can be provided digitally, site visits enable funders to physically validate company records and processes aligned with contracts.

Types of Facility Extensions

As forward flow contracts near maturity, companies seeking to renew agreements have several options including:

Straight Renewals – Continue with same terms
Expanded Tranches – Increase limits as business scales
Borrowing Base Adjustments – Tweak advance rates
Pricing Renegotiations – Attempt better discount rates
Tenor Extensions – Lengthen contract duration

Broader economic conditions also play a role if tighter credit markets limit availability.

Covenants and Defaults

Forward flow agreements contain highly restrictive covenants requiring tight operating controls to avoid technical defaults including:

Borrowing Base – Rigid caps on dilution and past due
Concentration Limits – Careful attention required
Late Reporting – Requires automation and procedures
Dilution Spikes – Revenue adjustments can trigger issues
Material Adverse Changes – Performance deterioration

Proactively flagging tripwires with investors and having waivers drafted helps minimize interruptions to financing availability.

That covers the key elements around forward flow agreements and facilities. Let me know if you need any clarification or have additional questions!