Invoice factoring, also known as accounts receivable financing or just “factoring”, is a type of financing where your company “sells” some or all of your outstanding invoices to a 3rd party as a way of improving your short-term cash flow. It does this by providing immediate working capital against the value of your open invoices. A factoring company will, usually within 24 hours, pay you most of the invoiced amount then collect the invoice payment directly from your customers when its due.
How Exactly Does it Work?
- Your business performs a job/service
- Instead of sending an invoice to your customer that could take 30-90 days to receive payment, you send the invoice to the factoring service
- They will advance your company payment based on the value of the invoice (typically 80-95% depending on risk/industry)
- When the invoice is due, the factoring service collects payment directly from your customer
- Once the invoice is paid, the factoring service will either pay any remaining balance to you minus a fee and/or withhold part of the payment in a reserve account as a safe guard against future customers that pay late or default
Here’s an example:
Let’s say you have a $1,000 invoice. You send that invoice to the factoring service. They deposit $850 into your bank account usually by the next day as long as you have your invoice in by a certain cut off time. The 15% is on hold until they get paid from your customer. Once they are paid, let’s say in 30 days, a percentage may be put into your reserve and they keep a percentage for the service (this fee varies by company). The reserve builds up over time with your money that they are in control of. Some services will release these funds to you by request as long as you have a good relationship with low risk customers.
If they aren’t paid by your customer within a certain amount of time (in your contract), they can take the money they couldn’t collect from your reserves and a penalty may be included.
The factoring company may deny some invoices if customers have bad credit. If you build a good relationship with the factoring company and have strong reserves, this may not be as much of an issue as they can collect payment from your reserves if necessary. Most factoring companies offer a login to track your customers’ outstanding invoices and may allow you to assist with contacting customers to pay the factoring company to avoid penalties.
What Are the Advantages?
Some businesses find getting a loan from a traditional lender difficult and slow to obtain but getting working capital from invoice factoring can be a faster option, often with much less paperwork involved than a traditional loan. In summary, invoice factoring can be:
- Easier to qualify for than traditional loans for some businesses
- Quicker funding than some loans, sometimes as fast as 24 hours
- Faster payment on invoices to help with cash flow
- Rarely have a time-in-business requirement; new businesses friendly
Are There Disadvantages?
There’s at least some disadvantages to almost every type of funding. Here are a few to consider when it comes to invoice factoring:
- Sometimes restricted by state (ex: many not available in California)
- Loss of control of your company’s accounts receivables
- Having a 3rd party contacting and collecting payment from your customers may come off as less professional to some
The Bottom Line
Invoice Factoring is one of the many alternative financing options available to small businesses and can be particularly beneficial to companies who utilize invoicing for their accounts receivable with long payment terms (30 days or more). It allows companies with this model to get faster access to the majority of their invoice payments. This, of course, comes with a cost which is the percentage that the factoring service keeps from invoice payments. That percentage can also vary based on your business model as they will take industry and risk of late payment from your customers into account. Most charge a 3-5% factoring rate, with higher fees for longer payment terms (ie. 30 days vs 90 days).
