Is Invoice Factoring Right For Your Small Business?

If your business has outstanding invoices and slow-paying customers, you don’t have to be burdened with cash flow issues. Invoice factoring could be the solution to your problem.

In this post, we’ll examine how invoice factoring works, whether it’s a good financial decision for your business, and how to choose the best invoice factor.

The Basics Of Invoice Factoring

Invoice factoring (or accounts receivable factoring) is when a business sells their unpaid invoices to a factoring company, at a discount, in exchange for immediate cash.

Factoring is generally used to solve cash flow problems caused by slow-paying customers. Instead of waiting for a customer to pay, small businesses can sell their invoices to a factoring company (also called a “factor”) to get the cash needed to maintain business operations or take on new projects.

How Does Factoring Work?

Typically, the factoring company will give you 85% to 95% of the invoice total upfront and hold a percentage of the invoice value in reserve until the customer has paid the invoice.

When the customer pays, the company will send you the reserved money, minus a factoring fee. A normal factoring fee (or discount rate) ranges between 1% and 6% per month. Fees can be accrued daily, weekly, or monthly, so the longer your customer waits to pay, the larger your accrued factoring fee becomes.

Here is an example of what a typical factoring arrangement might look like:

You sell an invoice valued at $5,000 to a factoring company. The factoring company sends you $4,500 (90% of the invoice value) and keeps $500 on reserve. Your factoring fee is 0.6% per week. Your customer pays after 35 days (or 5 weeks), so your fee is $180 ($30 per week). The factor deducts their fee, and sends the remaining reserve, totaling $320, to you.

Recourse VS Non-Recourse Factoring

Invoice factoring may sound great, but what happens if your customer doesn’t pay their invoice? Well, it depends on whether you have a recourse or non-recourse factoring arrangement:

• Recourse: You are entirely responsible for re-purchasing the unpaid invoice.
• Non-recourse: The invoice factor is responsible for the unpaid invoice.

Note: Most often, non-recourse factoring only covers clients who declare bankruptcy. The factor may still hold you responsible for paying back disputed invoices.

Spot Factoring VS Contract Factoring

In addition to recourse and non-recourse factoring, there’s also the option of spot factoring or contract factoring:

• Spot Factoring: Where you pick and choose which invoices you sell to a factor.
• Contract Factoring: Where you agree to a long-term contract to sell all (or most) of your invoices to a factor.

There are pros and cons to each option. Spot factoring enforces no long-term contracts or minimum volumes but does often involve higher factoring fees. With contract factoring, you’re locked into a factoring agreement and you often have to meet a minimum monthly volume, but you typically have lower factoring fees.

Invoice Financing VS Invoice Factoring

Invoice factoring isn’t the only way to leverage your unpaid invoices to get funding. There’s also invoice financing.

Invoice financing is technically a catch-all term for any form of financing involving invoices. There are two main types of invoice financing: selling your invoices (invoice factoring) or using your invoices as collateral for securing a loan.

Most often, when you hear the term “invoice financing,” people are referring to the latter, although you may hear the term accounts receivable financing instead.

With invoice financing, instead of selling your invoices, you’ll use your accounts receivable (unpaid invoices) as collateral to qualify for an asset-backed line of credit. With an asset-backed line of credit, a financer will grant you a credit facility based on the value of your unpaid invoices.

One of the other major differences between invoice financing and invoice factoring is that with invoice financing you are in charge of collecting the payments from your customers.

Conversely, an invoice factor has officially purchased the invoice, so they are responsible for collecting the customer payment, not you. While some factors may offer non-notification invoice factoring, most notify your customers that a third-party factor is collecting their payments.

Are You Eligible For Invoice Factoring?

If you run a B2B or B2G business and you invoice your customers, chances are you’re a good candidate for invoice factoring.

Unlike almost every other type of business financing, your business’s revenue and creditworthiness are not a major factor when determining eligibility. Invoice factors are more concerned with the creditworthiness of your customers because your customers are the ones actually paying the bills.

This makes invoice factoring a potential option even if:

• You have a new business without a financial track record
• You don’t make very much money
• You have poor personal credit

While these characteristics make it difficult to qualify for traditional business loans, you might still be eligible for invoice factoring based on the status of your accounts receivable.

Is Invoice Factoring Right For My Business?

You may be eligible for invoice factoring, but should you use a factoring service? There are benefits to factoring your invoices, but it’s not a perfect fit for all businesses. To determine whether factoring is right for your situation, ask yourself these three questions:

Are My Finances Suffering Due To Slow-Paying Customers?

If you aren’t paid for your work until months after you have completed the job, you might have trouble managing business expenses, purchasing inventory and supplies, paying employees, or covering overhead costs.

If this is the case, invoice factoring companies can be a simple way to ensure that you have the working capital you need to run your business.

Can I Afford Invoice Financing?

In general, factoring fees (or discount rates) range from about 1% – 6% of the invoice value per month, depending on your specific factoring arrangement.

If you sell an invoice from a particularly slow-paying client, and you have a high factoring rate, you could wind up paying around 18% (or higher) of the invoice value in fees for the opportunity to get your money sooner.

Many invoice factors also charge additional fees for factoring services. Business owners might be charged:

• Money transfer fees
• Servicing fees
• Monthly minimums
• Renewal fees

These fees can start adding up quickly over time.

All that said, your fees will depend on a number of components, including the factoring company you are working with, the creditworthiness of your customers, the number and size of the invoices you want to sell, the industry your business is in, and other considerations.

Would An Alternative Financing Solution Be A Better Fit?

Even if you decide that you need a financial solution, invoice factors most likely aren’t your only option. Now, more than ever, businesses have a plethora of financial solutions available. While invoice factoring might seem like the perfect solution to your cash flow problems, the following loan products might be a better fit:

• Asset-Backed Lines Of Credit: These credit lines can be backed by unpaid invoices or assets like inventory or receivables. While similar to invoice factoring, this option offers more flexibility and typically has lower rates than unsecured financing.
• Revolving Lines Of Credit: While some revolving lines of credit are backed with collateral, others simply require you to sign a personal guarantee or pledge assets via a blanket lien.
• Business Credit Cards: Business credit cards are great for unexpected expenses and can even put money back into your pocket with rewards programs. If you plan to carry a balance, be aware that credit cards have notoriously high rates and fees.
• Small Business Loans: If you need one-time funding or a large sum of money, consider a small business loan. Borrowers with high credit, an established business, and solid revenue will qualify for the best rates and terms.

How To Choose The Right Invoice Factor

Now that you’ve determined invoice factoring is right for you, the next step is choosing an invoice factoring service. There are many factors to consider when selecting an invoice factor, including:

• The factoring fee
• Any additional fees
• Recourse or non-recourse
• Notification or non-notification
• Whether the factor requires a long-term contract
• Which invoices you can factor

A good invoice factoring service is going to vary depending on your business’s specific needs, so take the time to decide which qualities are most important for your business and find a factor that meets those requirements.

Do your research and do some shopping around to find the best rates and fees available to you.