What is invoice factoring and how does it work?

Invoice factoring lets a business get cash now for a bill its customer won’t pay until later. The business first sells the unpaid invoice to a factoring company at a discount. The factoring company then typically pays 70% to 90% of the invoice’s value upfront and takes over collecting from the customer. When the customer eventually pays, the factoring company sends the business the rest minus its fee. The transaction is a sale, not a loan.

It can suit businesses that give customers 30, 60, or 90 days to pay but need money for expenses sooner.

What is invoice factoring?

Invoice factoring is a type of financing in which a business sells an unpaid customer invoice to a factoring company for cash now, rather than waiting weeks or months for the customer to pay. 

It’s also called accounts receivable factoring or receivable factoring. Accounts receivable are amounts customers owe your business for goods or services you’ve already provided. Businesses that bill other businesses or government agencies on net-30, net-60, or net-90 terms often have these outstanding invoices.

Once the factoring company buys an invoice, it takes over collecting payment from the customer. Your business receives less than the full invoice amount because the factor keeps a fee. The percentage of the invoice’s value you receive upfront is called the advance rate.

How does invoice factoring work?

How an invoice factor works can vary from company to company, but it generally starts with an application. You’ll provide basic information about your small business and the invoices you want to factor. The factoring company will pay particular attention to whether the customers who owe you money usually pay on time. If you’re having trouble collecting from a customer, the factoring company may decline to buy that customer’s invoice.

If your business is approved for a factoring agreement, the factoring company will pay you 70% to 90% of the invoice’s value. The amount can vary based on the company you choose and the quality of the invoices you factor.

The remaining portion of the balance, minus the invoice factoring fee, will be paid to you once the invoices have been paid. Some factoring companies send over the outstanding funds as invoices are paid; others send them in batches.

For example, say you factor a $10,000 invoice with an 80% advance and a 3% fee. The factoring company sends you $8,000 upfront and holds back $2,000. When your customer pays the invoice, the factor deducts its 3% fee of $300 from that holdback and sends you $1,700. In the end, you receive $9,700. 

But what if your customers fail to pay the invoice? That depends on the type of factoring you’ve agreed to: recourse factoring or non-recourse factoring.  

With non-recourse factoring, the factoring company assumes the risk that a customer won’t pay an invoice, subject to the terms of your agreement. For example, the agreement may cover a customer’s insolvency but not an invoice the customer disputes. Non-recourse factoring generally costs more because the factor takes on more risk.

With recourse factoring, your business may have to repay the factor if a customer doesn’t pay an invoice, depending on your agreement. You’ll often pay less in fees than you would with non-recourse factoring. Most factoring agreements tend to follow the recourse model.

Because your recourse obligations, as well as the process, rates, fees, and terms can vary, it’s important to thoroughly read and understand your factoring agreement and how the factored invoices will be handled so you can manage your business finances accordingly.

Invoice factoring requirements: Who qualifies?

To qualify for invoice factoring, your business needs unpaid invoices for work you’ve completed or goods you’ve delivered. The factoring company also needs to believe your customers will pay those invoices.

Factoring companies generally look at three areas:

• Customers: Invoice factoring usually involves bills sent to other businesses. If a customer has a history of paying late, the factor may decline to buy that customer’s invoice.
• Invoices: The factoring company will check how much the customer owes and when payment is due. It may also ask for proof that you completed the work or delivered the goods. If the customer disputes the invoice, the company may decline to buy it.
• Paperwork: You’ll fill out an application and submit the invoices you want to sell. Depending on the company, you may also need an accounts receivable aging report (a list of unpaid invoices and how long they’ve been outstanding), a tax ID, identification, bank account details, or business formation documents.

Each company has its own rules. Some require a minimum invoice amount or monthly volume, and some check your credit alongside your customers’ payment histories. Nav is not a lender or a credit bureau. Credit information is provided by third-party sources.

Invoice factoring rates and fees

One of the most confusing parts of invoice factoring is the cost. The factor makes money by charging a fee for the invoices it buys. Invoice factoring fees typically range from 1% to 5% of the invoice’s value per month, though your rate can depend on how many invoices you factor, your industry, and your customers’ creditworthiness.

Another consideration is how the factor charges that fee. Some factors use a tiered rate schedule, where the cost rises the longer an invoice goes unpaid. For example, if you factor $20,000 worth of invoices at 2% per month, you’d pay $400 if your customers pay within 30 days, $800 within 60 days, or $1,200 within 90 days.

Some factors charge a flat fee instead. In this case, you pay the same amount regardless of whether your customers pay in 30, 60, or 90 days. If you factor $20,000 worth of invoices at a flat 5% fee, you’d pay $1,000.

You may also have to pay fees in addition to the basic factoring rate. These vary by company, so check the agreement for application, servicing, processing, ACH, and monthly minimum fees.

Finally, check if the quoted percentage applies to the full invoice value or only the amount advanced. Have each provider show you the total cost in dollars so you can compare offers on the same basis.

Invoice factoring vs. invoice financing

It’s easy to confuse invoice factoring with invoice financing because the terms may be used interchangeably, but they work differently. With factoring, you sell an unpaid invoice, and the factor collects payment from your customer. With invoice financing, you keep the invoice and use it as collateral to borrow money. Your customer pays you, and you repay the financing provider, plus any fees or interest.

Industries where invoice factoring is common

Factoring is better suited to businesses that invoice customers and wait 30, 60, or 90 days for payment. Industries where it’s commonly used include:

• Manufacturing
• Technology and IT companies
• Staffing companies
• Import/export businesses, distributors, and wholesalers
• Government contractors
• Health care

Freight bill factoring

There is a specific type of factoring for freight and trucking called freight bill factoring. After your trucking company delivers a load, it can submit the invoice and bill of lading to a factor to get paid sooner instead of waiting 30 or 90 days; Nav’s guide to truck factoring companies explains how it works.

Is invoice factoring right for my small business?

Invoice factoring for your small business may be worth considering if your customers pay reliably but your expenses come due before they pay their invoices. It can be a fit when:

• You regularly send customers invoices and give them 30, 60, or 90 days to pay.
• You have limited or no business credit. Factoring companies generally put more weight on your invoices and your customers’ ability to pay than on your business credit history.
• You have seasonal shifts in business that result in gaps in cash flow.
• You need financing but don’t have collateral (e.g., equipment, automobiles, property) to secure another type of financing.
• Your business is growing and needs cash for supplies, inventory, or payroll before customers pay.

Even if several of these apply, look at what factoring fees would do to your margins first because you'll receive less than the full value of each invoice you sell. If you need the cash right away, you may decide the fee is worth paying. But if your margins are already tight and you haven’t priced factoring fees into your work, those fees can eat into your profits.

Before you enter into a factoring agreement, evaluate how it will affect your bottom line, and compare factoring with waiting for customers to pay or using another financing option.

Invoice factoring calculator

Using Nav’s invoice factoring calculator can help you estimate how the cost of factoring will affect your bottom line and compare it with other financing options.

Where to find invoice factoring

You can find invoice factoring through companies that focus on factoring and fintech lenders that offer it. Some factoring companies specialize in industries such as staffing or manufacturing. 

You can explore business financing options through Nav.

Invoice discounting and spot factoring

You may also want to consider invoice discounting or spot factoring if a standard factoring agreement doesn’t suit your business. Invoice discounting lets you borrow against unpaid invoices, while spot factoring lets you sell just one.

Invoice discounting is a short-term financing option in which you use unpaid invoices as collateral. A lender may advance around 80% of their value, though the amount varies. You continue collecting from your customers and repay the lender when they pay. Interest or discount charges, along with any service fees, add to the cost.

Spot factoring, also called single invoice factoring, is when a factoring company buys a single invoice as a one-time factoring transaction, typically a larger outstanding invoice. If your company finished a big job and won’t get paid for another 60 days, you could factor that single invoice without factoring the rest of your invoices each month. A factor may charge more for a one-time transaction than it would under an ongoing agreement, so compare the fees before you sign.

Disadvantages and risks of invoice factoring

Costs can be hard to predict. If your factor uses a tiered rate, you’ll pay more when a customer takes longer to pay. Additional fees can also raise the total. Before you sign an agreement, compare what factoring would cost in dollars with other financing your business could qualify for.

You give up control over collections. Once you sell an invoice, the factor contacts your customer about payment. Your customer may receive new payment instructions or hear from a company they never dealt with before. Ask how the factor introduces itself and follows up on late bills, since those conversations can affect your relationship with the customer.

You may still be responsible if a customer doesn’t pay. Under a recourse agreement, you could have to buy back the invoice or repay the advance if the customer doesn’t pay. Even with a non-recourse agreement, the factor may hold you responsible if your customer disputes the bill.

You could be locked into a contract. Some agreements require you to factor a minimum dollar amount each month, stay for a set term, or pay a fee to leave early. If you only need to factor an invoice every now and then, you could end up paying a monthly minimum when you don’t need the cash.

Frequently asked questions