If unpaid invoices are affecting your cash flow, invoice factoring may help get your finances back on track. Here's what you need to know about invoice factoring.
Looking for info about invoice factoring? Then you’ve come to the right place!
This cash flow problem-solver can be a tricky beast to tackle, but once you’ve got the hang of it, you’ll be able to get the money you need to run your business without having to wait around for clients to pay off their invoices. This means you can invest cash right back into your business, potentially enabling you to grow at a quicker pace than you might have otherwise.
We’ll be going into plenty of detail below, covering all the ins and outs of invoice factoring — from spot factoring and extra costs to terms and conditions worth knowing and everything in between.
What Is Invoice Factoring & How Is It Used?
On the surface, invoice factoring is simple. Businesses sell their invoices at a discount to factoring companies (also known as factors) in exchange for cash up front. This allows a business to operate normally without losing money because a client is slow to pay.
Many businesses in the B2B sector take advantage of factoring. Common industries that use factoring include transportation, government contractors, staffing companies, advertisers and media companies, and any other business that invoices customers.
Put plainly, plenty of merchants employ factoring to keep their businesses running smoothly. If your business operations are impacted by cash flow problems because your clients take too long to pay their invoices, factoring may be for you.
How Invoice Factoring Works
Invoice factoring starts off with a simple transaction when a business sells outstanding invoices to a factoring company. However, the business won’t get the full cash amount of their invoices.
Instead, the factor will hold a small reserve of between 5% – 30% of the invoice value until the customer has paid. This is done so that the factor can protect against risk. The fee for factoring, called the discount rate, and any chargebacks or refunds will come from this reserve.
A typical factoring interaction might look like this:
You sell an unpaid invoice with a value of $10,000 to a factor. The company advances you 85% (or $8,500) of the cost upfront and holds 15% (or $1,500) in reserve. When your customer pays, the factor will send you the reserve, minus a small fee.
Recourse VS Non-Recourse Factoring
In general, there are two types of factoring — recourse and non-recourse. The difference between the two determines who is responsible if the customer does not pay their invoice.
With recourse factoring — the more common type — you are responsible for paying the bill if your customer cannot or will not pay. Because this arrangement is not as risky for the factor, they’ll normally charge smaller fees. However, an unpaid invoice can present a problem for your business if you do not have the means to cover the costs.
Non-recourse factoring works differently. If your customer does not pay, the factoring company must simply write off the debt. Under non-recourse agreements, there are still cases in which you will have to re-purchase unpaid invoices (like if the customer refused to pay because you did not fulfill the order correctly). Non-recourse factoring tends to be more expensive because of the additional risk.
Spot Factoring VS High Volume Factoring
Spot factoring’s primary advantage is that you have complete control over which invoices you sell to the factoring company. The more traditional form of factoring (also called high-volume factoring) usually requires that you enter into a contract where you agree to sell most or all of your invoices.
With spot factoring, you also won’t have to worry about extra fees beyond the basic discount rate. However, this discount rate will usually be higher than what you’ll pay with high-volume factoring. If you’re looking for non-recourse factoring, but also want to go the spot factoring route, you may be out of luck. That’s because spot factoring is inherently riskier to the factoring company, making features like non-recourse factoring less attractive to offer.
The Differences Between Invoice Factoring And Invoice Financing
You may have run across the term “invoice financing” when delving into the world of invoice factoring. Both these financial tools offer ways to smooth out cash flow; however, they are separated by some notable differences:
- Invoice financing is a loan where you put up your customers’ invoices as collateral. Once you’ve collected your customers’ debts, you’ll pay back your loan.
- Invoice factoring involves a transaction where you sell your invoices to a factoring company. This company then typically collects your customers’ invoices on your behalf.
For a full run-down on the differences between factoring and financing, visit our breakdown.
The Costs Of Invoice Factoring
Factors charge a discount rate when you sell an invoice. Many also charge other fees for certain services. Here is what to expect:
The Discount Rate
The discount rate is normally between 1% – 6% per month. Depending on the factor, the rate might accrue on a daily, weekly, or monthly basis. Your fee will be deducted from your reserve (the amount of the invoice that the factor holds back). The longer your customers take to pay, the larger the fee will be.
Your fee is dependent on how risky the factor perceives the transaction to be. If your customers are not creditworthy or your business is in a risky industry, you might have higher fees.
For example, if you have a fee of 4% on an invoice worth $1,000 and your customer takes 60 days to pay, you will have a fee of about $80. If your customer takes 90 days, your fee will be about $120.
Other Common Fees
In addition to the discount rate, your factor may charge fees for application, maintenance, or other reasons. Here are common fees you may encounter:
- Application Fee: Some factors will charge you to evaluate your application and/or set up the financial arrangement. This fee may be charged up front or waived until you factor your first invoice.
- Diligence Fee: Also known as a setup fee, this charge is another upfront fee. It’s used to perform credit checks, as well as other costs associated with opening an account.
- Maintenance Fee: Also known as a servicing or administration fee, this is a catch-all fee used to cover any and all costs associated with keeping your account current.
- Lockbox Fee: The factor may charge you a flat fee to keep a lockbox open. This lockbox is a designated account where your customers will pay their invoices to.
- Wire Fee: This fee could come about if you choose a wire transfer instead of an ACH transfer (which is preferred by most factors).
- Early Termination Fee: Many factors require a contract that usually lasts between six and 18 months. If you need to bow out early, you’ll usually get dinged with a cancellation charge to get out of the contract.
Common Terms & Conditions You Should Know About
There are a number of terms and conditions you must consider to find a factor that will work for your business.
- Contract Length & Termination Notice: Contract length and termination notices vary between factors. Some require long-term contracts and charge fees for canceling before the contract is up. Others may simply require advanced termination notice.
- Which Invoices Are Factored: Most companies will let you choose which invoices you decide to sell (as long as the invoice is from an approved customer), but some will require that you sell all invoices from specific customers or all your invoices period.
- Monthly Minimums & Maximums: Some factors will require you to sell a certain amount of invoices to them each month, or conversely, may cap the amount that you’re allowed to sell.
- Notification VS Non-Notification Factoring: For whatever reason, your business may need to keep your factoring arrangement discreet. If so, you may be able to set up a non-notification agreement, which means that your customers do not know that you have sold their invoices. On the other hand, notification factoring means that your customers are aware of the arrangement.
Alternatives To Invoice Factoring
Invoice factoring doesn’t work for everyone. If invoice factoring doesn’t seem like the right funding option for you, consider these alternatives.
Invoice Financing
As mentioned above, you can take advantage of invoice financing instead of factoring. Of course, note that invoice financing is technically a loan — you’ll put up your outstanding invoices as collateral. Then a lender will give you a line of credit based on the value of those invoices. Once your customers have paid off their invoices, you can then pay back the lender.
Invoice financing can be more flexible than factoring because you usually get to pick and choose which invoices get financed. On top of that, things can be more private; with invoice financing, your customers may not know that you are involving a third-party because they only interact with you. Factoring, on the other hand, usually involves the third-party reaching out to customers — potentially providing a clue that you’re having cash flow problems.
Traditional Line Of Credit
Another option is to get a traditional business line of credit. Going after a line of credit may require additional legwork. Lenders look at more data points than just your outstanding invoices. Your business will usually need a healthy credit score, have not gone into bankruptcy recently, and have a decent level of revenue. Lenders may also consider the age of business and any available collateral.
Note that a line of credit isn’t a loan — instead, you gain access to a certain amount of money that you can draw from at any time. One of the more common lines of credit is a credit card (although there are other types, too).
Additionally, it’s worth a mention that even if you have poor credit or have other negative marks against your business, it isn’t impossible to obtain a line of credit. Negative marks will just make it more difficult
How To Find An Invoice Factor
Ultimately, you’ll want to find a factor you can trust. On top of that, you’ll need to work with one that offers terms and conditions that best fit your business.
Factoring, unfortunately, isn’t a one-size-fits-all industry. A factoring company that works for someone else may not work for you, so make sure to do your research before entering into an agreement.
Because eligibility for invoice factoring is contingent on the creditworthiness of your customers (and not the health of your business), invoice factoring is a relatively cheap source of financing that will work for a lot of businesses. This means that you should be able to find a company that will fit your needs without breaking the bank.
