Part one of a two-part series on Invoice Financing by Ed Castaño, VP of Operations at BlueVine— a venture backed, technology enabled, factoring company providing working capital financing to small businesses.
Waiting to get paid is one of the biggest frustrations for any company. B2B companies, especially those that work with large companies, face this pain acutely. Their customers frequently demand generous terms or are slow payers (government and corporate clients are specially guilty of this practice). It’s extremely difficult to manage cash flow when invoices are outstanding 30, 60, or even 90 days. Freeing up that cash would allow most small business to make important investments in their business, expand or meet critical expenses, like payroll, for instance. Few small businesses know is that there is a solution to alleviate the pains of lumpy cash flow and long payment cycles: invoice financing. Invoice financing (aka accounts receivable financing), can turn your unpaid invoices into funds to fill a working capital gap.
How it works
The terms “invoice financing”, and “invoice factoring” are often times used interchangeably because both solutions are structured very similarly. Typically, three parties are involved in the transaction: the small business requesting the advance, the customer of the small business or “debtor” on the invoice, and the invoice financing company that advances payment on the invoice. When the small business delivers the product or service, they issue an invoice. The financing company purchases the invoice from the business, and in return the business receives an advance, typically 80-90% of the value of the invoice. With the cash on hand, the small business can pay employees, take on additional work, or buy additional inventory. Once the invoice is paid (almost always directly to the financing company), the small business receives a “rebate” for the remainder of the funds, minus the discounting fee, which is calculated based on the length of time the invoice was outstanding. The outcome: the customer gets favorable payment terms, the company gets immediate access to cash, and the financing company collects a fee. Everyone benefits from the arrangement, a sure sign of a good deal.
Invoice financing vs. invoice factoring
The key difference between invoice financing and invoice factoring is that, formally, invoice factoring involves the purchase of the invoice without a personal guarantee from the small business owner. If the debtor does not pay the invoice, the business is not liable for the payment of the invoice to the factoring company. In contrast, invoice financing contracts contain a personal guarantee clause so the provider is somewhat protected against losses.
Like anything in life, invoice financing has its pros and cons. A less taxing application process, fast funding, and a higher approval rate are the main advantages to invoice financing relative to bank loans. With access to funds you can improve your profitability by taking on additional work, getting supplier discounts for early payment or bulk purchases, or purchasing equipment to improve your production. A simpler application process improves on some of the major hurdles that banks place on small businesses. The quick speed to getting funds allows a small business to take advantage of time sensitive opportunity or avoid delaying critical payments. The higher approval rates relative to banks means that you may qualify for invoice financing even if a bank has rejected you. Funding from invoice financing can also complement your bank line of credit if you need additional cash for your business.
The main disadvantage of invoice financing is that it is a more expensive form of financing relative to a bank loan. That may be of little relevance for the 80% of small businesses that are declined for a bank loan. In contrast, more than 50% of businesses that apply are approved for invoice financing. Nonetheless, it’s important to understand that your margins can sustain the costs of invoice financing. In other words, you want to be confident that taking an advance on your invoices still gives you a positive return (ROI). Another disadvantage of invoice financing is that many companies require a formal notification of your customers and may even take over your account receivables and collections function. While some factoring companies see this as a benefit, many small businesses are uncomfortable with these conditions. If you are interested in working with an invoice financing company, make sure you understand their terms.
All kinds of industries are eligible for invoice financing, including: construction, staffing, transportation, wholesale trade, medical services, manufacturing companies, and IT companies. Business services like design, marketing and PR industries are especially well suited for invoice financing because their corporate clients demand such generous payments terms. B2B companies that issue invoices, due between 15 and 90 days are the best candidates for invoice financing. Their lumpy cash flow and long payment cycles make it particularly appealing to get financing on their unpaid invoices. Companies that work primarily in retail or with consumers, or that don’t issue invoices because they are paid upon receipt, are not good candidates for invoice financing.
You should now have a good basic understanding of invoice financing. Before deciding if invoice financing is a good fit for your business, make sure you’ve read this handy beginner’s introduction to business financing, and the accompanying 10 types of business financing summary guide to get a solid understanding of all the options available to you. Alternatively, after reviewing the options, you may decide to avoid financing altogether and shoot for small a business grant instead. That’s ok, but be aware that as the equivalent of free money, finding small business grants you may qualify for is not easy. However, if you’ve determined that invoice financing could be a good fit, read our guide on identifying an invoice financing provider that is right for your business.
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