Invoice factoring is a form of business financing that could save you from having to take a loan from Tony Soprano.
Invoice factoring is the act of selling the debt on one or more outstanding invoices to another business. The business that buys your invoice debt is called a factor.
The factor pays you an amount equivalent to what the invoices are worth, minus a percentage. The benefit is that you get paid sooner, giving you working capital to pay your bills. The drawback is that it reduces how much you ultimately get paid by your client. This is sometimes called "receivable financing" since you're trading your accounts receivable for cash.
To factor an invoice, it must have a term of 30 to 90 days. Generally, it takes two to seven days to qualify for invoice factoring, and another one to two days to receive payment from the factor. Sometimes factoring companies will check out the creditworthiness of your clients, too—they want to make sure they're not dealing with people who won't pay their invoices.
Here's a super simple example. Let's say you run a landscaping business. You've just sent your client Greg an invoice for $2,000, payable in 60 days.
Problem is, you need cash ASAP to buy a new leaf blower. So you factor Greg's invoice. The factoring company gives you $2,000, minus a few percent to cover their rates. Now, you have the cash in hand. And once Greg pays his invoice, the factor will have their money as well.
How it differs from other financing options
Factoring is not considered a small business loan, because there isn't anything to pay back. The onus is on the factor to collect the receivable and get paid.
And unlike a line of credit, it's a one-time infusion of cash, directly related to invoices you agree to finance. A line of credit is an ongoing source of capital you can draw from when needed.
Here are the common rates and fees you expect a factor to charge.
When you factor invoices, you can expect to receive about 80% of the value of your accounts receivable upfront. You'll get the other 20%—minus the factor rate—once the client pays their invoice.
The factor rate (also called a discount rate) is a percentage of the invoice value, charged weekly or monthly. The industry standard is 0.5"“5% per month.
A lot of factors have a tiered system. The longer your client takes to pay an invoice, the higher the factor rate.
Here's a step-by-step example using Greg. This example doesn't use a tiered system, and doesn't take into account additional fees (discussed below).
All these fees will be spelled out in a factoring agreement, which you may be able to negotiate, depending on the vendor.
In addition to the factor rate, factors may charge additional fees. Before you sign up for factoring, find out whether you'll be charged any of the following:
When it comes time to choose an invoice factor, consider what is most important to you. For instance, would you be willing to sacrifice relationships with customers in order to get paid sooner?
That may or may not be a decision you have to make. Before signing any formal agreements with the factor, be prepared to ask the following:
Sometimes the terms invoice factoring and invoice financing are used interchangeably. However, they're two different financial services.
With invoice factoring, a factor buys your accounts receivable (the money people owe your business), assuming a certain amount of responsibility for them. That includes the responsibility to collect money from your clients.
With invoice financing, you still own your accounts receivable. The invoice factoring company just looks at it, calculates how much you're expecting to get paid and when, and gives you a cash advance against that amount—typically around 80% of the total invoice amount, and the rest when the customer pays you (minus a percentage for their fee, of course).
Factoring costs less for you (the small business owner), but requires you to hand over control of your accounts receivable to another company. Financing, on the other hand, lets you hold onto your accounts receivable, but costs more.
There are two different ways you'll work with a factor: on the spot, or by contract.
With spot factoring, you make a one-off deal with a factor. This is good if you've only got a few invoices you want factored, but don't want to make it a habit. The downside to spot factoring is that it usually costs more than contract factoring.
Contract factoring involves establishing a relationship with a factor, and factoring your invoices regularly. You're typically covered for a certain amount of factoring you can "use" per period. This amount is called your factoring facility.
This is a good choice if you want to speed up your invoicing cycle, and make factoring part of your regular cash flow. It's also cheaper than spot factoring. However, you have less freedom—your factor may penalize you if you don't use a certain portion of your factoring facility every period.
Let's go back to the Greg example. Say you factor that $2,000 invoice, but once it's time to pay, Greg stops picking up his phone or answering his email. The factor you sold Greg's debt to can't collect the money.
Now what? That will depend on what kind of factoring you're using—recourse factoring, or non-recourse.
With recourse factoring, even after you've sold an invoice, you're still liable for whether it gets paid or not. If the factor can't collect on an invoice, you have to pay them the full amount. You may also need to pay a penalty fee. The recourse method is the most common type of invoice factoring.
Following our example, once 60 days has passed and Greg hasn't paid, the factor comes back to you. They demand the full $2,000. Hopefully, you have it on hand. Otherwise it may be time to call ol' Tony Soprano.
(Just kidding. Never call Tony.)
Recourse factoring means you need to make certain adjustments in your books. Any recourse you need to pay a factor must be tracked as a liability. We won't get into detailed bookkeeping here—just know that, if you use recourse factoring and you're a Bench client, we'll take care of it for you.
With non-recourse factoring, you're not liable for unpaid invoices. The factor buys the invoice outright, and assumes the risk of non-payment.
Sounds perfect, right? Naturally, non-recourse factoring comes with a couple of caveats.
First of all, because it's riskier, factors will charge you more for non-recourse. The difference could be as much as a percentage point—say 3% of the amount you're factoring, vs. 2% if you used the recourse method. And if your clients have a low credit score, those invoices might not be eligible for non-recourse factoring, since they're a higher risk.
Second, you may still be liable. Every contract with a factor has its stipulations. It's common for factors to only assume risk in case of bankruptcy. In that case, if one of your clients goes bankrupt, you're fine. But if they dissolve their company and catch a flight to the Cayman Islands, you're still on the line for the money they owe.
Invoice factoring is just one way to get immediate cash for your small business. And no, we're not talking about loan sharks. There are at least seven (legal) ways to get cash, fast. However, factoring won't solve underlying cash flow problems. Learn how to better manage your cash flow here.
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