Invoice factoring is when a business sells the invoices owed to them at a discount to a third party called a factoring company, and the factor company collects from the business’s customer directly.
The business selling their invoices is not required to tell the customer, but the customer will receive a notification of assignment from the factor company. It is a good idea for companies that use invoice factoring to let their customers know someone else will be collecting the money owed, as a way to avoid any surprises.
The discount you sell the invoices for is called the factor rate and determines how much cash you get:
- Cash from invoice factoring = invoice total * factor rate
- For example: If you sell $100,000 for a factor rate of 5%, you’d get $95,000.
Factoring an invoice is different from getting a small business loan because you’re selling the invoices instead of borrowing money, meaning there is nothing to pay back. You still get financing, but instead of paying interest over time to a lender, the drawback with factoring is that the factoring company gives you less than the invoice amount based on the factor rate.
Your customer’s business credit score and financial history are two of the things a factoring company looks at when deciding whether to offer financing, so make sure they’re in the clear. If financial statements show a lack of cash flow or a low business credit score, the factoring company may reject buying the invoices due to a lack of confidence in being able to collect repayment.
Factoring invoices can be a good option in some cases, like when loan approval is unlikely, when time is of the essence, or when the business loan interest rate is higher than the proposed factor rate. But it’s not the best option in many other cases. In this guide, we’ll explore how the process works, when it makes sense, and when to avoid using it.
The Invoice Factoring Process
Factoring invoices is a 5-step process:
- A company invoices a customer.
- The company negotiates terms with a factoring company, including the factor rate and any additional fees or withholding amount (where the factoring company withholds a buffer in case of collection trouble).
- The company with the invoice signs over the legal right to collect to the factoring company (like signing over a check to someone else).
- The customer pays the factoring company.
- If any funding was withheld, the factoring company pays the original company any amount still due.
It is an easy process and can help you get immediate cash to grow your business instead of having to track down customer payments.
When Invoice Factoring Makes Sense
Invoice factoring is a good idea when:
- You have sales but can’t get a traditional small business loan.
- There’s no time to wait for traditional bank approval processes.
- Interest rates are higher than the proposed factor rate.
Invoice factoring makes sense when you can’t get a traditional small business loan because of your credit score, lack of collateral, or another reason.
A B2B kitchen equipment supplier to hotels that wants to start selling B2C or to restaurants can use invoice factoring for advertising, setting up an ecommerce store or showroom, and hiring new staff. Traditional lenders may decline their application as this business could be considered too risky to enter into a new market. In this situation, the equipment supplier could combine invoice factoring with inventory financing to stock up on consumer items that work as loan collateral. This could make approval easier to come by, given the lower risk to the lender.
Factoring an invoice also makes sense for unexpected opportunities like buying a competitor that just announced they’re going bankrupt. Because a traditional expansion loan with a large bank can take weeks, invoice factoring (which gets you the cash fast so that you can close the deal before someone else does) could be preferable.
Another good use of invoice factoring is paying off debt where the interest rate is higher than the factor rate:
- A 1-year loan of $100,000 at 10% costs you about $10,000 in interest expense. This makes the total payback amount $110,000.
- With a 5% factor rate on $110,000 worth of invoices, the cost would be $5,500, and you’d get $104,500 back.
Pro-tip: Make sure there are no curtailment penalties (prepayment penalties) so you don’t lose the gains in fees.
Even though invoice factoring makes sense for these situations, there are drawbacks, which can sour business relationships and hold businesses back.
Times to Avoid Invoice Factoring
The times to avoid invoice factoring include the following situations:
- You’re not confident that your customer can pay.
- You have plenty of cash on hand and future cash flow to fund operations.
- There is already a strain on your customer relationship.
When you have a strong relationship with a customer, but their industry is in a temporary downturn that will last a year or two, a small business loan will be better than invoice factoring. This is because the factoring company can come after you through a recourse agreement (recourse means you’re responsible until the invoice is paid) if the customer doesn’t pay.
It’s possible to negotiate what’s called a non-recourse agreement, where they can’t hold you liable when customers don’t pay. This lowers your risk but will make the factor rates higher because it’s a higher risk for the factoring company.
In terms of the next situation, you’ll get less than the total invoice value when you use factoring. So, this type of financing doesn’t make sense when you have more than enough cash on hand and stable future cash flows to cover expenses. If you’re buying a $50,000 piece of equipment and have $100,000 in the bank, it doesn’t make sense to give up 5% or more of an invoice’s value by factoring when you can use cash.
Another reason not to factor invoices is the possible strain on customer relationships. Once you assign the invoice to the factoring company, you don’t control how they collect, and they could pester or harass your customer and damage the relationship.
Using invoice factoring can allow you to focus on operations and future growth instead of collecting payments, making it a great option to get cash fast in some situations. When you have time to go through the business loan approval process though, or if you already have decent cash on hand, invoice factoring won’t make sense given the various drawbacks.
