Invoice factoring is a type of business financing that allows a company to get an advance on funds to cover its unpaid invoices. It can help your business with cash flow, as you don’t have to wait for customers to pay an invoice. The invoices are assigned to a factoring company, which will then provide up to a 95% advance and work directly with your customer to receive payment. However, fees on invoice factoring can be much higher than other forms of business financing.
Small businesses needing to factor invoices can do so with FundThrough, which offers a fast application and an invoice assignment process that can sync seamlessly with your QuickBooks or OpenInvoice account. The application process is simple and entirely online.
How Invoice Factoring Works
Invoice factoring is not considered to be a loan, but rather an advance. When you are looking to sell and assign an existing invoice, you can do so through an invoice factoring company that will enter an agreement with you, provide the funds upfront, and obtain repayment from your customer directly.
Below are the generally applicable steps of how invoice factoring works.
The factoring company will conduct due diligence on your invoiced customers to see if they are good credit risks and determine the fees and the discount rate based on their creditworthiness.
Once approved, you’ll submit your invoices, and the factoring company will give you an initial advance based on the agreed-upon advance rate, also known as the borrowing base. The advanced amount will depend on your transaction’s size, industry, and other risk parameters.
Your client will pay the factoring company according to the terms of the invoice. The factoring company will handle the collection of all invoices you assign to it, as governed by the Federal Assignment of Claims Act.
It will try to follow your history of collection techniques unless the client is past due and may also send a “notice of assignment” to your invoiced clients. The notice states that your business has assigned the factoring company as the entity to receive future payments for invoices you issue.
After receiving payment from your client, the factoring company will give you the remaining balance of the invoice, called the reserve amount, minus its fees. For example, If your advance rate was 80% with a monthly factor rate of 3% and your customer repaid within 30 days, the factoring company will pay you the remaining 17%.
Types of Invoice Factoring
There are various forms of invoice factoring, each of which has different purposes and applicable business uses. Here is a list of the types of factoring available from invoice factoring companies:
- Recourse factoring holds your business liable if your customer fails to pay the invoice to the factoring company; it is a higher risk for your company, but rates and fees tend to be lower
- Nonrecourse factoring doesn’t hold your business liable for unpaid invoices; however, it is only available to businesses with numerous invoices
- Spot factoring is a common form of factoring for small businesses because business owners can factor specific invoices as needed as opposed to all invoices
- Contract factoring is a factoring agreement that sets a minimum monthly factoring amount to remain in good standing; this type of factoring is less common with new factoring companies but is usually required for large financing agreements
- Nonnotification factoring is an uncommon type of factoring; this agreement prevents the factoring company from communicating with clients
- Debt factoring is another term for invoice factoring, usually requiring the business to sell the entire batch of invoices for a particular debtor
- Advance factoring is a common form of factoring where a part of the advance is given to the business, with the factoring company keeping some percentage
- Maturity factoring entails the sale of invoices for a set value and rarely grants the business additional payments when the factoring company collects an invoice
Rates, Terms & Qualifications of Invoice Factoring
There are other fees associated with invoice factoring. They can vary depending on the company and transaction, so be sure to review them carefully before signing an agreement. You may not come across all of them, but here are some you may encounter with invoice factoring:
- Origination fees: These are upfront costs associated with starting a new factoring relationship and opening your account; these could be up to $1,000.
- Incremental fee: If your discount rate is a flat fee, then you may be charged an incremental fee to increase the total discount paid as an invoice ages. This fee can be as high as 1%.
- Collection of overdue fees: The factoring company may charge you for its efforts required to collect past due payments from your customers. These fees vary and could range from nothing to a few thousand dollars.
- Unused line fee: This is charged for the unused portion of a factoring facility for a given month. It is typically stated as a percentage and charged on a monthly basis. It can range from 0.15% to 0.5%.
- Monthly minimum volume fee: If you don’t generate a certain level of fees for your factored invoices in a given month, the factoring company may charge you a fee as high as $1,000.
- Renewal fee: The renewal fee is an annual fee applied after every full year the line is open. This could be up to 1% of the factoring facility size.
- ACH Automated clearing house transaction fee: This is a fee of up to $30 that is charged for every advance or disbursement issued to you.
- Wire fee: This fee is charged if you request to receive a wire instead of an ACH. The charge can be as high as $50.
- Credit check fees: These are small in comparison to the other fees, but these may be passed on to you for any credit checks performed on you or your customers.
Invoice factoring is a good working capital solution for businesses of varying sizes and ages, as long as your business has qualifying invoices. Rates and terms can vary depending on your business needs and the participating invoice factoring company.
You can qualify for invoice factoring if invoices are due within 90 days and you have no serious tax or legal problems. Some factoring companies will work with startups, while others require at least a few months of business operations.
Qualifying for invoice factoring is often easier than qualifying for long-term financing. You typically qualify if you have B2B or B2G clients. While credit scores and debt service coverage ratios (DSCRs) can be significant hurdles for other types of financing, they are less often issues with invoice factoring.
Pros & Cons of Invoice Factoring
| PROS | CONS |
|---|---|
| Financing decisions are based mainly on the creditworthiness of your customer rather than your business. | Some customers may disqualify you from financing if they have less-than-ideal creditworthiness. |
| It offers access to cash to keep up with business operations and avoid a gap in cash flow. | Overall costs and fees can be higher in the long term |
| There’s an opportunity to work with experienced accounts receivable experts. | There are reduced profits due to interest and fees due to the invoice factoring company. |
Who Invoice Factoring Is Right For
Invoice factoring can be a valuable financial solution for some businesses. It may work for you, if
- You need quick access to cash: Businesses that are looking to keep up with demand and continually grow their company can benefit from invoice factoring to have a consistent stream of cash flow.
- You have a gap in cash flow: For businesses needing to bridge a gap in cash flow, invoice factoring can provide a cash advance that will allow them to maintain operations and cover other business expenses instead of waiting on a customer to pay an invoice to receive funds.
- Your customers are creditworthy: Invoice factoring companies will typically only work with businesses that have reputable customers. This is due to the fact that they will be working directly with a business’s customers to receive payment once it’s factored the invoice to them.
How to Get Invoice Factoring
There are numerous invoice factoring companies that can facilitate a transaction. To be considered eligible, you’ll need to meet the necessary qualifications and prepare your application accordingly. The general process is as follows:
- Step 1: Invoice your client. Once you have provided products or services to your B2B or B2G customer, you issue an invoice for them to pay. If you need guidance, refer to our article on how to collect and track outstanding invoices. To qualify for invoice factoring, these invoices must be payable within 90 days by the customer.
- Step 2: Review your qualifications. When shopping around for an invoice factoring company, ensure you meet the minimum qualification criteria before applying. This includes factors such as time in business, annual revenue, and the creditworthiness of your customer.
- Step 3: Compare rates and terms. Conditions of the agreement will vary per company and transaction, so be sure to compare the proposed rates and terms of the factoring company you’re interested in.
- Step 4: Sell and assign the invoice to a factoring company. After you’ve found a factoring company you want to work with and it approves your business, it will enter into an agreement with you. The agreement will set an initial maximum dollar amount that you can borrow and will list fees and service charges that will apply. Our roundup of the best invoice factoring companies contains our recommended providers.
Alternatives to Invoice Factoring
Invoice factoring can benefit a variety of businesses and be a valuable financial tool. However, if you think it may not be the right fit or are simply exploring all of your financing options, here are some alternatives you can consider:
- A/R financing: While similar to invoice factoring, A/R financing (also known as invoice financing) differs in that it’s more like a loan. Instead of selling your existing invoices, you can borrow against them. Essentially, a lender finances your outstanding invoice upfront, and you’ll repay it directly instead of your client. See our list of the best A/R financing companies for options.
- Working capital loan: Whether you need short- or long-term financing, there are a variety of working capital loan types that can support your business financially. They can include a line of credit, SBA loans, or more specific loan types—such as equipment or hard money loans. Check out our roundup of the best working capital loans to find a provider.
- Business line of credit: This is a revolving credit facility that allows you to request a draw and have the funds deposited into your account of choice. It can be used on an as-needed basis for generally any business expense, and the balance you accrue can be repaid over time. To learn more about rates, terms, and requirements, check out our guide on small business lines of credit.
- Business credit card: Similar to a line of credit, a business credit card is a revolving credit facility that can be used to make as-needed business purchases. You can make a purchase directly and repay the balance as it accrues over time. It is best used for small recurring charges rather than large capital expenses. Our roundup of the leading business credit cards contains our recommendations.
- Merchant cash advance: This is a business financing product that allows companies to receive a lump-sum advance payment in exchange for a fixed percentage of their daily credit card receipts. MCAs are an expensive form of credit and should only be used as a last resort by businesses that cannot qualify for other forms of financing. If you are interested in this option, check out our list of the best MCA companies.
Frequently Asked Questions (FAQs)
Generally, the process involves invoicing your client for your product or service, sourcing an invoice factoring company, selling the invoice to them in exchange for an advance, and them taking on the responsibility of obtaining repayment from your customer. Once the invoice is satisfied, the transaction is considered complete.
Invoice factoring can be costly due to the various fees involved with the transaction. More importantly, you’ll need to consider the discount rate, which is charged per month and will leave you with less profit than the original invoice.
For example, assume you factor a $100,000 invoice at an advance rate of 80% and a discount rate of 3% per month. In our example, you would receive $80,000 upfront. If your client makes full payment on the invoice within 30 days, the factoring company keeps its discount rate fee of $3,000 and will pay you the remaining $17,000 you are due. The total amount you receive is $97,000.
Bottom Line
Now that you know how invoice factoring works, you can determine if it is applicable to your business financing needs. It can be a valuable financial tool to support your company, whether it be to sustain cash flow or use the advance for other business-related expenses. However, it can be costly with various rates and fees, so be sure it fits your budget and explore all financing options before committing to this route.
