This post was reviewed and updated on July 6, 2020
Pro tip: What you don’t know can kill your business
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Many, roughly eigthy-two percent, of small and medium-sized businesses fail because of cash flow problems. And while there are many factors that can impact cash flow, past-due invoices, or an aging accounts receivable, can account for a fair share. Even if customers regularly pay their invoices on time, the lag between the payment terms small businesses offer to their customers and when those invoices are paid can contribute to cash flow challenges.
Fortunately, there are a number of financial tools available to business owners to help manage gaps in cash flow. From small business loans and lines of credit to purchase order financing and cash advances, there are many ways you can weather gaps in cash flow. However, if you have net 30, net 60, or net 90 terms with customers, you may want to consider invoice factoring.
What is Invoice Factoring?
Invoice factoring is a financial transaction in which a business sells its accounts receivables (invoices) at a discount to an external financing company, known as a factor or factoring company. Factoring companies typically advance 70-90 percent of the invoice value up front.
In the simplest sense, invoice factoring, also referred to as accounts receivable factoring, is the sale of your outstanding invoices to a third-party, or factor, in exchange for cash to cover the cost of day-to-day operations or other expenses. Though often listed among business financing options, true invoice factoring is not a bank loan, or any kind of loan. Instead, it’s a finite transaction that results in the transfer of goods — i.e., invoices — from your business to the factoring company. In other words, factoring is the sale of your accounts receivable at a discount to the factor for access to capital today, rather than 30, 60, or 90 days from now.
As a result of this transaction, the factoring company takes ownership of collection efforts. This is important to note as it’s the defining characteristic separating invoice factoring and invoice financing, the difference of which we’ll cover below.
How does invoice factoring work?
As with many other small business funding solutions, how an invoice factor works and their process can vary from company to company. Generally, it begins with the application process.
Applying for factoring is similar to applying for any other type of funding. You’ll need to provide basic information about your small business, though the factoring company will take far more interest in the quality of your unpaid invoices. In other words, if you are factoring because you are having a problem collecting from your customers, the factor will be less interested in your invoices compared to a small business with customers that regularly pay their invoices on time as agreed upon.
If approved for a factoring agreement, the process will begin and the factoring company will issue a cash advance for a percentage of the agreed upon amount — usually between 80% and 90%, though it can vary based on the company you choose and the quality of invoices to be factored.
The remaining portion of the balance, minus any additional invoice factoring fee, will be paid to you once the invoices have been paid. (In some cases, factoring companies will send over the outstanding funds as invoices are paid. Others will batch them.)
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.
Non-recourse factoring contracts involve the factoring company assuming the total risk for the invoice. If the client fails to pay the invoice, you won’t be held financially responsible. This also means the factoring company will charge more in fees for the assumed risk, but it may be worth the price.
Recourse financing is just the opposite – your company would liable for any unpaid invoices. Many factoring companies will provide credit checks on your debtors before you pull the trigger, and you’ll often save more in fees than you would with the non-recourse route. 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 rates & fees
One of the most confusing parts of the factoring equation is cost, particularly the rates and fees. The factor earns profits based upon the difference he or she pays you for the invoices and the face value of the invoices.
There are really no standard percentages (but there are some industry standards). You should expect to negotiate with the factor based on a variety of factors, including the number of invoices you plan to factor, the industry you are in, and your customer’s creditworthiness, but you can typically expect a factoring fee between .05% and 4%.
Another consideration to keep in mind is how the lender will assess fees. Generally, they do so using a tiered rate schedule, where fees are assessed based on how long it takes for your customers to pay (factors tend to work in specific industries and will use industry-norms to calculate this).
For example, if you plan to factor $20,000 worth of invoices, and the fee is 2% per month, you would pay $400 in fees if the unpaid invoices were paid in the first 30 days, $800 if they paid within 60 days, and $1,200 if they paid in 90 days.
Some factors also apply a flat fee. In this case, you can expect to pay the same amount in fees regardless of whether the customers pay in 30, 60, or 90 days. For instance, if you planned to factor $20,000 worth of outstanding invoices and the factor applied a 5% fee, then you’d pay $1,000 in fees, whether the invoice was paid in 30 days or 90 days.
In addition to the basic factoring rate, you may also be required to pay additional fees. These also will vary by company. Keep an eye out for application fees, servicing fees, processing fees, ACH fees, and monthly minimum fees.
Invoice factoring vs invoice financing
If you’re considering invoice factoring, it’s also a good idea to become familiar with invoice financing. Though they aren’t identical, you’ll find that the two terms may be used interchangeably.
Instead of selling your invoices or account receivables, as is the case with factoring, invoice financing allows you to borrow against outstanding accounts—in other words, your Accounts Receivable acts as kind of a collateral on your loan and you collect from your own customers, rather than the factor. Once your client(s) pay you, you’ll repay the lender the agreed upon value plus and fees or interest.
The two terms are often used interchangeably by some — but they are not the same thing. Though they both leverage your invoices, invoice financing or accounts receivable financing allows you to borrow against outstanding accounts. Once your customer(s) pay you, you’ll repay the lender the agreed upon value plus any fees or interest. Financing does not result in a sales transaction.
Industries where invoice factoring is common
The nature of factoring makes it better suited for some industries more than others. If your accounts receivable don’t operate on a 30-,60-, or 90-day payment cycle, then factoring likely won’t be the right option for you. Some of the industries were factoring is a good fit include:
- Tech & IT companies
- Staffing Companies
- Import/export, Distribution, or Wholesalers
- Government Contractors
- Health care
Freight Bill Factoring
There is a specific type of factoring for freight and trucking, called freight bill factoring. Simply, your trucking company delivers the goods to the customer and submits the bill of lading to the factoring company. Rather than waiting 30 or 90 days to be paid, this can allow your small business to get the money in your bank account within 24 hours of submitting the paperwork.
Is invoice factoring right for my small business?
Maybe your business fits into one of the categories above, or maybe you meet the basic requirement of invoice-based client payments. If you’re not sure if it’s the right move for you, then here are a few reasons why it may be:
- You offer your customers payment terms, bill on invoice, and have a substantial number of invoices each month.
- You don’t have credit. Because approval ways heavily on the quality of your invoices, not your credit history, this can be a good option for small businesses working on building or establishing credit.
- 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.
- You’re a new and quickly growing business that needs additional working capital to manage immediate cash needs for purchasing inventory or supplies.
Still, even if one or more of the above are true of your business, there are still other things to consider.
Factoring rates and fees will inevitably result in less money coming into your business than you had originally planned. Sometimes, particularly when time is of the essence, that won’t matter as much. However, if you can wait for invoices to be paid, it’s generally a better idea to do so—if you haven’t added additional margin to accommodate for the factoring costs.
If you’re already operating with tight margins, then invoice factoring can eat into your profits. That can obviously have a negative impact on your bottom line.
Before you enter into a factoring agreement, it’s important that you evaluate how it will impact that bottom line. That means you’ll need to compare whether waiting it out or seeking assistance through alternative financing options will be the better decision.
Invoice Factoring Calculator
Using an invoice factoring calculator can help you evaluate and compare your options as well as determine how it may impact your bottom line.
Best invoice factoring companies
BlueVine is an invoice factoring company that offers B2B customers invoice factoring up to $5 million with an 85% – 90% cash advance and rates as low as .25% per week. The application typically takes about ten minutes with decisions made in as little as twenty-four hours.
To be eligible for invoice factoring through BlueVine, you must have a FICO score of 530 or higher, be in business for 3 or more months, and have annual revenue of at least $100,000.
Fundbox offers invoice financing (not factoring) that allows you to borrow up to $100,000. Why include them on this list? They are one of the few companies that allow business owners to access a line of credit for up to 100% of the value of their invoices, up to the amount for which they are approved.
In essence, Fundbox offers invoice financing as a line of credit with 12 to 24-week repayment plans. You can use as much of your approved line of credit as needed, and you’ll only be charged fees on what you use.
Fundbox doesn’t have a minimum credit requirement or time in business stimulation. You will, however, need to use supported accounting software and show a minimum annual revenue of $50,000 and three months of invoice activity.
Newtek offers funding from $50,000 to $1.5 million, and business owners will receive up to 80% of the invoice amount as a line of credit. Terms are twelve months, but they can be renewed.
Newtek’s prides itself on individualized financial solutions, and therefore they don’t provide general information about their rates. You can discuss potential rates by contacting Newtek.
Invoice Discounting and Spot Factoring
As a last resort, you may also want to consider invoice discounting or spot factoring. These are alternative ways of using unpaid invoices as collateral for a loan, but comes at relatively high prices.
Invoice discounting is typically a very short-term financing option in which an unpaid invoice are used as collateral. The amount of debt issued by the lender is usually 80% of the amount of outstanding invoices. Invoice discounting companies will collect your interest payments as well as a monthly fee for managing the transaction, making this a relatively expensive form of financing.
Spot factoring is when a factoring company buys a single invoice as a one-time factoring transaction, typically a larger outstanding invoice. Because of the singularity of the invoice being sold, this is a much higher-risk transaction for banks as opposed to a more typical factoring agreement, in which numerous invoices would be included.
Both invoice discounting and spot factoring offer a certain flexibility and resource for companies that may have exhausted all other options. While they come with a high price in the form of either interest or fees (or both), they may be what your small business needs to stay afloat.
Invoice Factoring FAQ
Is invoice factoring easy to qualify for?
Invoice factoring is often considered easier to qualify when compared to other types of financing, like a small business loan or line of credit.
Generally, your business must operate as a formal legal structure, such as an LLC, C Corp, or S Corp, that provides goods or services to commercial or government entities. Further, because factoring requires the sale of invoices of accounts receivable, you must run a business that offers goods or services in exchange for payment at a later date, e.g., net 15, net 30, net 90, etc.
In addition, every invoice factoring service will have their own set of requirements. Typically these will include credit considerations as they relate to your customers, as opposed to you or your business. This is because factoring services prefer to purchase invoices that are likely to be paid within the agreed upon time.
That’s not to suggest that your credit history won’t be considered at all. Most invoice factoring services will factor it in, but it likely won’t play as significant a role in approval as it would for traditional lending applications.
Can you do invoice factoring with no credit check?
Invoice factoring is often considered a funding option for small business owners with bad or non-existent credit. That’s primarily because the risk associated stems from the customers, not the business owner.
Still, many factoring companies do still run a credit check as part of the application process. The good news is that many factors have low or no minimum credit score requirements.
Can you qualify for invoice factoring as a startup?
In short, yes. You can take advantage of invoice factoring or financing as a startup company.
If you’re a startup seeking this kind of funding, you’ll need to take special note to any time in business or annual revenue requirements. For some startups, particularly those in the very early stages, meeting these requirements can be challenging.
Other financing options if factoring isn’t right for your business
In addition to factoring, there are other options including cash flow loans and other small business loans. Business credit cards may also be an option because the qualification criteria is often less stringent than other small business loan options.