Being a small business owner is very rewarding and a source of pride. But there are many things beyond your control, even when you run your own company. Operating expenses like paying rent and utilities on time, paying employees—and yourself—often depend on your accounts receivables. And falling behind is not an option. That's where invoice factoring comes in.
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Updated January 19, 2022
What Is Invoice Factoring?
Invoice factoring is a transactional-based method of business financing for small businesses. Invoice factoring is not a loan, it’s a transaction. It involves selling part or all of your unpaid invoices to a third party who then collects the invoice amounts due on the invoices.
Invoice factoring is also referred to as accounts receivable financing or receivable financing and is designed for small business owners who wish to increase their immediate cash flow. This can be used for any purpose including working capital.
How does invoice factoring work?
As mentioned above invoice factoring is a type of financing where a small business owner agrees to “sell” or assign unpaid invoices or outstanding invoices to a third-party such as a lender who provides factoring services. That invoice factoring company pays small business owners a discount rate or an advance rate on the face value of the invoices, then collects the full value of the invoices. The invoice factoring services make their money on the spread between the total invoice amount and the discount rate they pay the small business owner.
A typical scenario may work as follows:
- Small business owner sells products or services to their customers as they normally do.
- The customer is invoiced as usual.
- The small business owner then sells or assigns the right to collect the full value of outstanding invoices to an invoice factoring company through an invoice factoring agreement. The invoice financing company then pays a percentage of the invoice value to the business owner immediately after doing the due diligence that the invoices are valid. The amount of invoice discount and upfront payment can vary on a number of factors including the types of business, age of the outstanding invoices, and other factors.
- The customers will then pay the invoice financing company directly (they are essentially an accounts receivable facility). They will also pursue late payments from customers.
- The invoice financing company will remit any portion of funds from paid invoices (minus any additional fees, if applicable).
Example of Accounts Receivable or Invoice Factoring
- Business owner typically generates 200 invoices per month at an average of $500 per invoice, or $100,000 per month.
- Clients generally pay in 30 days. Business owner may have up to $300,000 (or more) in accounts receivable at any given time.
- Factoring Lender agrees to provide capital directly to the business owner for 80% of the invoice value ($300,000 x 80% = $240,000) on the business day the factoring agreement is signed.
- Factoring company collects payment and charges the business owner any additional fees.
Advantages of Invoice Factoring
- Increased cash flow – Invoice factoring can accelerate cash on-hand versus waiting for clients to pay their outstanding invoices. If your small business offers payment terms to clients, you will typically have to wait 30 days to get paid. For companies with many clients, this could add-up to a lot of money.
- Outsourcing overhead for accounting – It also may relieve the business owner from the responsibility of chasing payments and accounts receivable. This eliminates accounting overhead by assigning the job of collections to a third party. In many cases, the additional fees charged by factoring services is less than maintaining accounting staffing.
- High Approval Rates – Compared to other types of financing such as: business loans, traditional bank loans, term loans, lines of credit or other financing options, invoice factoring has very high rates of approval. In addition, invoice factoring companies rarely require a credit check, minimum credit score or a report on credit worthiness or personal credit. Receivable factoring relies mainly on the validity and value of the invoices.
Disadvantages of Invoice Factoring
- Requires a large amount of clients – In order to be profitable and minimize risk, factoring companies generally look for companies that have a relatively large amount of outstanding invoices. So if your company has only a few clients this may not be one of the best financing solutions.
- May require signing long-term contract – For larger companies with a lot of customers, factoring companies may require a longer-term commitment such as one or two years…or more. This is not necessarily a cause for concern, as taking-over collections for a large amount of client can be complex and take time to transition. So, business owners should manage expectations and evaluate whether a long-term commitment is in their best interest.
There are alternatives for companies wishing to use invoice factoring on a small level for shorter periods. These arrangements are sometimes referred to as spot factoring or selective factoring which will be discussed below.
- Hidden Fees or higher costs – When doing due diligence on your customers and the validity of your invoices, factoring lenders may assign a risk class to the value of the invoices. The risk class is a measure of the amount of risk the lender is taking. If your invoices appear to be risky (some clients may not pay) then you may have to pay higher fees or the invoice discounting may be larger. In addition, some companies may charge your small business a a monthly minimum fee for their services.
- Recourse for non-performing invoices – “Recourse” is an important term in an invoice factoring agreement. It means that the factoring company has recourse for clients who don’t pay their invoices. Put simply, they can charge you back for clients who do not pay. The charge could be the amount of the upfront payment, plus a service fee.
- May be harmful to your relationship with customers – Any time you outsource a portion of your business you run the risk that the third party do not maintain the same standards as you or your staff would. And when it comes to collections, you want to ensure that your clients are treated professionally, with respect…and sometimes with a bit of leniency. But understand that when you enter into an agreement, most times you give control to the factoring company. If they are too aggressive in their collections activity, that could cause harm to your relationship with your clients.
Your Responsibilities in the Factoring Process
As a responsible business owner, you’ll want to work with a qualified, well-reviewed factoring company. Here’s what to look for:
- How quickly they can fund your cash advance.
- How much they charge for their factor fee.
- Is their service non-recourse or with recourse?
- The factoring company will want to examine your company’s financial stability, and they may want to verify how credit-worthy your customers are. You may need to give them access to client credit information.
What Is Invoice Funding?
There is an alternative to invoice factoring called invoice funding (or invoice financing). Invoice funding is different from the factoring process because you still own your accounts receivables, but you use them as collateral, so the cash advance you receive is similar to a loan.
While this option can work for your business, remember that it is riskier because you’re still responsible for guaranteeing your accounts receivables.
What Are the Types of Invoice Factoring?
If you’re concerned about selling all of your accounts receivables to a factoring company, consider your options.
Spot Factoring means you sell a few or a single invoice on a one-off basis with no long-term contract. You get a great deal of flexibility with spot invoice factoring, but you may face a higher factor fee.
Whole Ledger Factoring
With whole ledger factoring, you must sell your entire book of accounts receivables and sign a contract (this is also called full turn factoring). While some business owners are wary of this, you can expect to pay a lower factor fee.
Non-recourse factoring is when the factoring company has no recourse in the event your client does not pay their invoice.
Selective factoring is a type of invoice factoring where individual or small bundles of invoices are factored, as opposed to large amounts or the entire sales ledger.
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The iCapital Business Loan Insider blog is full of timely articles that will help you understand some of the challenges faced by many small business owners like yourself. From new products for small business loans to emerging trends and regulations, iCapital is engaged in the business of small business loans ownership at many levels. If you have a story idea you would like to share or want us to cover a specific topic such as small business funding, small business operations, or marketing, let us know and we will try to add it to an upcoming article or social media post.
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