What is Invoice Financing?
Invoice financing is a catch-all term to describe a number of business financing products that are backed, in some way, by unpaid invoices. These products can be useful for B2B businesses with slow-paying customers.
There are three types of invoice financing products: invoice factoring, a/r backed lines of credit, and non-traditional invoice financing.
What is Invoice Factoring?
In the past, the invoice factoring industry has had a reputation for being non-transparent and restrictive. However, in general, the practice of factoring invoices is useful for B2B businesses that are strapped for cash. Furthermore, while there are certainly a few bad eggs that contribute to the industry’s poor reputation, many factoring companies do not engage in dubious practices.
Invoice factoring is a relatively simple concept: you sell your unpaid invoices to a factoring company in exchange for money up-front. In most cases, the factoring company will give you 70% – 95% of the invoice value (the “advance rate”) up-front, and give you the remaining 5% – 30% (the “reserve”), minus a fee for their services, after your customer has paid the invoice.
Because the company is purchasing your invoices outright, invoice factoring is not technically a loan product.
Invoice factoring can get complicated in the details, however. Although the general concept is the same, factoring companies might differ in regards to fees, contract term lengths, which invoices you’ll be required to factor, whether your customers know about the arrangement, and so on.
Here are common ways invoice factoring arrangements may differ:
Contract Term Lengths and Termination Notice
Some factoring companies require contracts of a certain length and charge fees for early termination; others do not require long-term contracts at all. It’s important to know what a potential factoring company requires in terms of contract length and termination notice.
Factoring All Invoices vs. Invoice-by-Invoice
Some companies require that you sell all your invoices, period. Some require that you sell all invoices from specific customers. Others operate on an invoice-by-invoice basis, which means you have control over which invoices you choose want to sell to the company.
Recourse vs. Non-Recourse
This determines who is responsible for paying if your customer defaults on the invoice. If you are in a recourse agreement, you are held liable for the unpaid invoice. If the agreement is non-recourse, the factoring company absorbs the loss. Because non-recourse arrangements are more risky for a company, they tend to cost a little more.
Notification vs. Non-Notification
Most customers have no problem with their unpaid invoices being sold to a factoring company. However, some businesses may not want their customers to know about the arrangement.
For a more thorough rundown of invoice factoring basics, check out this article.
What is an A/R Backed Line of Credit?
If invoice factoring isn’t flexible enough for your needs, you may be able to get an A/R backed line of credit instead. Unlike invoice factoring, A/R backed lines of credit are loans. The total amount you may be able to borrow is contingent on your invoices, but instead of selling them outright, the invoices are used as collateral.
Lines of credit may be useful for businesses that want a little more flexibility than invoice factoring normally offers. Borrowing is not tied to invoices, so you can choose exactly how much and when you would like to borrow capital. In addition, repayments are made over a set period of time, so you will always know exactly how much you are being charged for the service.
If you need a larger credit line, some A/R backed lines of credit can use other forms of contractual revenue, such as inventory or monthly recurring revenue, as collateral.
Other Types of Invoice Financing
In the past few years, some funding companies have developed variations on traditional invoice factoring or A/R backed lines of credit. Although the products differ in some ways, most are intended to provide flexible financing options, and carry fast, streamlined application processes.