Risks versus Rewards

Excerpted from "What Every Lender Needs to Know About Working Capital Lending"

The reason for "usury" is to compensate the lender for the risks they are taking in the lending transaction. The margins created by the lending transaction are what compensate the lender for taking on a particular risk. In working capital lending, the margins created must be continually managed and monitored to prevent possible impairment.

If a risk is realized, the reward is eliminated. Any lender who has ever made a loan that went bad and was uncollectible knows that the rewards they received on that loan through usury usually fall far short of the losses ultimately realized from the default of the loan.


In a working capital loan, the pricing and structure of the transaction is critical to maintaining the risk-mitigated margin. The pricing and structure must be flexible since all loans are unique. Each element is critical to maintaining a proper mitigation of risk.


It is critical that the lender have complete pricing flexibility in order to maintain the appropriate margin to mitigate the risks of the transaction. The lender should be able to structure the loan for a particular borrowing base in such a way as to reflect the risk taken in that borrowing base. Forcing a pricing schedule on a lender that does not take into consideration the risks of the transaction would put the lender in a situation where a substandard loan could easily be made.


Another consideration in looking at risk versus reward is the velocity of money. The following diagram shows the velocity of money as it relates to a receivables portfolio:


In that 30-day period, the lender would have put the same dollar out on 3 different advances. Each of those advances would have had a 1% discount point charged as part of the accounts receivable purchase transaction. The 85% advance would have been rendered 3 times as profitable for this lender as it would be to do 1 - 85% advance on 1 receivable that paid in 30 days.

To make things comparable across different receivable payment scenarios, a person could easily price the discount fee to be graduated or variable. The graduation could occur daily or in a time interval. For example, in each 10-day increment the discount rate could be increased. This way, the lender is able to eliminate any risk with regard to pricing and get an enhanced yield at the same time through the velocity of money.

It is this velocity component that makes most accounts receivable purchasing programs the highest yielding working capital lending transactions that a lender could ever employ.

Using the velocity of money can also show the flip side as to how a lender can lose money in an accounts receivable purchase transaction if they don’t have a component that allows them to take advantage of the velocity of money and therefore are forced to make all their advances using a fixed discount fee.

A comparison between fixed pricing and graduated pricing shows how a lender can get upside-down using fixed pricing if an invoice takes longer than expected to pay.


Working capital lending, when done correctly, is a “win/win” proposition.

The customer wins by allowing their receivables to be purchased by the lender or directly liquidating a line of credit. This provides a tremendous benefit to the business by:

• Immediately eliminating their cash flow gap
• Providing a continuous working capital flow to the business
• Increasing the value of the business by enabling the business to have adequate cash to pursue all opportunities presented to them within their operational capacity

The lender equally benefits by:

• Being able to provide all the above benefits to their customer
• Making high margins with mitigated risks

Risks and rewards should be safely tied together in a working capital loan in a way that allows the lender to receive the highest reward for the lowest risk transaction.