When business owners are trying to get working capital to finance their business operations, the first choice is often a small business loan or line of credit. But if you can’t get approved for a loan, or don’t want to borrow money at the moment, there are also some alternative finance options to help your company get a quick influx of cash.
One of the “non-loan” forms of small business finance is factoring, also known as accounts receivable financing. Factoring can be a viable option for your business to get cash when you need it most—but it’s important to be aware of the possible drawbacks before you commit to working with a factoring company.
Factoring is a unique type of cash advance financial service where companies can get money by trading their unpaid invoices to a factoring company or “factor,” which then collects payment on the business’s behalf. With factoring, instead of getting paid directly by your customers in the usual way, your company agrees to give your unpaid receivables to a third-party firm (the “factor”) that gives you cash upfront as a certain percentage of the total value of the outstanding receivables.
How Factoring Works
Let’s say your company needs quick cash, and has $100,000 in receivables for a particular month. You could sell those receivables to a factor, which would typically pay you 75% of the value of the receivables upfront, followed by an additional percentage payment after the factor collects payment from your customers.
Factors make money by keeping a percentage of the value of your invoices—usually 2% to 6%—so you do have to give up a percentage of your profits in order to work with a factor. In this example, assuming that your factor charged a fee of 6% of the value of the receivables, your company would get $75,000 upfront, and then an additional $19,000 within 30 to 90 days after all payments had been collected.
So instead of getting all $100,000 from those receivables (and waiting to get paid), you would get a total of $94,000, with $75,000 collected immediately. However, you would also have to pay interest to the factor on that $75,000 cash advance—and interest rates depend on your overall creditworthiness, the quality of your receivables, and the terms of your deal.
Points to Consider
Factoring is actually a very old form of business finance, and it is quite common in certain industries where slow-paying receivables are the norm. Although factoring can be a good option for your company to raise an immediate influx of working capital, you have to weigh the benefits against the possible costs and drawbacks of factoring.
Benefits of factoring include:
- Immediate Cash: Factoring gives your company an immediate cash influx when you need it most. Instead of waiting 30 to 60 days or more for all of your customers to pay their bills, you can get an immediate windfall all at once.
- No Loans: Factoring is not the same as a loan—it does not affect your credit score or require you to make ongoing payments. Factoring is just a simple trade: Giving up a percentage of future profits in exchange for immediate cash today.
- Keep Your Equity: Factoring does not require you to sell any percentage of your company or share equity as you would have to do with raising capital from investors. Instead of taking out a long-term loan or giving up equity to new investor-partners, factoring can be a one-time decision to get cash for a specific business goal, or to recover from a temporary financial setback.
Possible drawbacks of factoring include:
- Reputational Risks: When your business works with a factor, your customers will be notified that the factor is now responsible for collecting their payment. Often this is no big deal—factoring is a legitimate and longstanding business practice. But some customers might get confused, or start to worry that your business is having cash flow problems, or wonder if your company is at risk for going out of business. So communicate upfront with customers if you decide to use factoring—explain the situation and reassure their concerns.
- Change in Business Processes: Depending on your deal with the factoring company, the factor might want you to make some changes in your business operations or payment processes. For example, you might be encouraged to stop doing business with certain customers who have poor credit or slow payment histories. Be prepared to give up some control over your business if you want to get money from a factor.
- Costs: Factoring is not cheap. In addition to giving up a percentage of your total profits in each batch of receivables that you finance, you have to pay interest on the cash advance provided by the factor. Depending on the terms of your agreement with the factor—which vary by your credit score and your customers’ likeliness to quickly pay their bills—the total costs of receivables financing can be significant. So make sure to read the fine print and understand what you are agreeing to before you commit.
Giving up a percentage of your total profits is never an idea that is taken lightly by business owners. However, factoring can be a worthwhile solution to help your company get quick cash without some of the long-term commitments and costs that are related to getting a small business loan or raising capital from investors. Just be sure that you understand all the details, costs, and risks before you sign on to the factoring agreement.
Kabbage offers the security of a business line of credit and helps business owners qualify in minutes. This commitment to the small business community has allowed Kabbage to fund over $1.6 billion and gain the trust of more than 100,000 small business owners.