How Invoice Factoring Works

Businesses that invoice clients can assign unpaid invoices to a factoring company to get fast cash. For a fee, the factoring company advances a portion of the invoice value to the business. The factoring company then collects payment from the invoiced client and sends the business the remaining invoice balance. That’s how invoice factoring works.

BlueVine is the best invoice factoring company available for small business owners. It offers an online application, has low minimum requirements, and can factor up to $5 million per month.

5 Steps to Factoring an Invoice

With invoice factoring, your account receivables (invoices) due within 90 days are sold to a third party. It’s a quick and easy immediate cash source. You’ll receive an initial advance of approximately 80% of your invoice upfront. Once your customer pays the invoice, you’ll receive the remaining 20% (minus fees).

The five steps in invoice factoring are invoice your client, sell and assign the invoice to a factor, factor issues an advance on the invoice, client pays the factor, and factor forwards you the remaining balance (minus fees).

1. Invoice Your Client

Once you have provided products or services to your business-to-business (B2B) or business-to-government (B2G) customer, you issue an invoice for them to pay you. To qualify for small business invoice factoring, these invoices must be payable within 90 days by the account debtor.

2. Sell & Assign the Invoice to a Factor

Before being able to receive factoring financing, you will need to find a factoring company you want to work with and then go through the application process. The factor will determine if you meet the eligibility criteria to receive financing and conduct due diligence on the customers you’re invoicing to see if they are good credit risks. There are several common invoice factoring mistakes to avoid at this step.

If the factor approves your business based on that research, you and the factor will sign a factoring agreement. The agreement will set an initial maximum dollar amount that you can borrow, which is the maximum factored amount outstanding. Ensuring that customers pay on time and are creditworthy is one of the best ways to improve an invoice factoring application.

3. Factor Issues an Advance on the Invoice

After submitting your invoices, the factor gives you an initial advance based on the agreed-upon advance rate. The advance rate is around 80% of the value of the factored invoice, known as the borrowing base. The amount of your advance depends on the size of your transaction, your industry, and other risk parameters.

The factor may also send out a “notice of assignment” to the clients you have factored, or it may ask you to do so. The notice of assignment states that your company has assigned the factor as the entity to receive future payments for invoices you issue it. All payments will go to a lockbox account, such as a designated account for the factored invoices to be paid, which is set up by the factor.

Some industries are more accustomed to invoice factoring than others. Trucking and shipping companies use freight factoring and, in industries like construction, factoring is common. In industries where factoring is common, telling a client you’ve assigned their invoice might not be a problem. If factoring isn’t common in your industry, you might benefit from invoice financing, which doesn’t require invoice assignments.

4. Client Pays the Factor

Your client will pay the factor within 90 days according to the terms of the invoice. The factor will handle the collection on all the invoices you assign to it, governed by the Federal Assignment of Claims Act. The factor tries to follow your history of collection techniques unless the client is past due. This means there is no negative impact on your customers.

5. Factor Forwards You the Remaining Balance (Minus Fees)

After receiving payment from your client, the factor will give you the remaining balance of the invoice, called the reserve amount, minus its fees. While factoring companies don’t disclose an APR, business owners can estimate the costs using an invoice factoring calculator. For example, if your advance rate was 80% with a monthly factor rate of 3%, and your customer repaid within 30 days, the factor would pay you the remaining 17% at this point.

Who Invoice Factoring Is Right For

Invoice factoring is right for businesses needing a consistent cash flow solution and that invoice at least $25,000 per month to B2B or B2G customers. If you choose business factoring, you need to be prepared to bring the factor in as a partner on your accounts receivable management and collections processes. Some business owners need money to order goods for completed orders and may leverage a letter of credit to access financing.

The types of invoice factoring include:

• Recourse factoring: The factoring company will collect directly from the business if it cannot collect from the account debtor.
• Nonrecourse factoring: The business is not liable for unpaid invoices. This type of factoring is only available to businesses with numerous invoices.
• Spot factoring: Common form of factoring for small businesses because business owners can factor invoices as needed.
• Nonnotification factoring: Uncommon, but available factoring agreement that prevents the factoring company from communicating with clients.
• Debt factoring: Another term for invoice factoring, usually requiring the business to sell the entire batch of invoices for a particular debtor.
• Advance factoring: 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.
• Contract factoring: A factoring agreement that sets a minimum monthly factoring amount to remain in good standing. This is less common with new factoring companies but usually required for large financing agreements.

Invoice Factoring Qualifications

Invoice factoring is a good working capital solution for businesses of many ages and sizes as long as your business has qualifying invoices. You can qualify for invoice factoring if you have been in business for at least three months, have invoices due within 90 days, and have no serious tax or legal problems.

Qualifying for invoice factoring is easier than qualifying for long-term financing. If you have B2B or B2G invoices due within 90 days and no recent tax or legal issues, you can qualify for invoice factoring. While credit scores and debt service coverage ratios can be significant hurdles for other types of financing, they are less often issues with invoice factoring.

Most factoring companies consider:

1. Who you invoice: You must invoice business (B2B) or government (B2G) customers. Your customers must have good credit scores, and they must be established businesses. The factor will need to feel comfortable that your customers are likely to pay off your invoice.
2. When invoices are due: The invoices must be due and payable within 90 days and unencumbered by other loans. For example, you can’t have another short-term loan outstanding where the same invoice is pledged as collateral.
3. Credit history: Your business should not have a history of serious tax or legal problems.

Some factors will have other requirements for your business, such as a minimum credit score or minimum time in business, but these requirements are usually far less stringent than other lenders. Comparing the qualification requirements of the leading invoice factoring companies can help you decide which factoring company is best for your business.

Invoice Factoring Rates & Fees

The primary cost associated with factoring financing is the discount rate, which is sometimes referred to as the factor rate. Invoice factoring rates range from 0.5% to 5% of the amount of the invoices factored. Factoring companies may charge additional fees, such as origination fees or minimum factoring fees. It’s important to be aware of what these fees may be.

The base cost (without additional fees) of an invoice factor depends on two things:

• Discount rate or factor rate: The discount rate is the primary cost of borrowing money from the factor and is typically charged on a weekly or monthly basis. The industry range is 0.5% to 5% of the invoice value per month. Many factors have a tiered system for discount rates, so the more you factor in a month, the lower your rate is.
• Length of factoring period (the time it takes your customer to pay): Discount rates are charged at regular intervals―usually weekly or monthly―so the time it takes for the customer to pay your invoice will determine your cost.

Example of Invoice Factoring Costs

Let’s illustrate the terms above with an example. Suppose you factor a $10,000 invoice at an advance rate of 80% and a discount rate of 3% per month. Here, you would receive $8,000 upfront. If your client makes full payment on the invoice in 30 days, the factor will pay you the remaining $1,700 you are due, bringing the total amount you receive to $9,700. The factor keeps the remaining $300.

For example, factoring a $10,000 invoice would look like this:

Other Invoice Factoring Fees to Look Out For

Besides the discount rate charged on your factored invoices, there are other fees that you may encounter when using business factoring financing. Some factoring companies may charge origination fees, services fees, collection fees, or an assortment of other fees. It’s important to understand any fees it may charge you as part of your factoring agreement.

Some additional fees you may encounter with invoice factoring include:

• Origination fees: 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 to the factor as an invoice ages. This fee can range from 0.35% to 1%.
• Service fee or lockbox fee: This is a flat fee that your factor may charge you to keep open a lockbox, such as a designated account for the factored invoices to be paid, to which your customers will pay their invoices. It can range from $50 to $500 per month.
• Collection or overdue fees: Your factor may charge you for its efforts required for collecting past due payments from your customers. These fees vary by factor and could be nothing to a few thousand dollars.
• Unused line fee: Charged for the unused portion of a factoring facility for a given month. It is typically stated as a percentage and charged monthly. It can range from 0.15% to 0.5%.
• Monthly minimum volume fee: In the event that you don’t generate a certain level of fees for your factor in a given month, it may charge you a fee of up to $1,000.
• Renewal fee: An annual fee applied after every full year the line is open. This could be up to 1% of the factoring facility size.
• ACH transaction fee: A fee of $5 to $30 that is charged for every advance or disbursement issued from the factor to you.
• Wire fee: Charged if you request to receive a wire instead of an automated clearing house (ACH), which is the preferred method of payment by most factors. The factor passes on the charge from its bank to you, typically $15 to $50.
• Credit check fees: These are small in comparison to the other fees, but your factor may pass the cost on to you for any credit checks it needs on you or your customers.

Any additional fees that may be charged by the factor should be stated in your factoring agreement. Read through the agreement carefully to make sure you understand what the fees are and when the fees apply. If you are applying with multiple factors to see which one will offer you the best deal, compare the fees and discount rates each charge.

How to Choose the Right Invoice Factoring Company

There are several aspects to consider when choosing an invoice factoring company. You need to determine the level of customer interaction you are comfortable with the factor having with your customers, and how quickly you need funding, whether you want recourse or nonrecourse financing, and whether you want spot factoring or contract factoring; these will impact the factoring company you choose.

Some things to consider when shopping for factoring financing are customer contact with the factor, time to get funding, recourse vs nonrecourse factoring, spot factoring vs contract factoring, and industry familiarity.

Customer Contact With the Factor

One aspect of invoice factoring that intimidates a lot of businesses is the level of contact between the factor and your customers. This worry stems from the fact that your customer will make payments to the factor instead of to you. Some small business owners imagine this will cause hard-earned customers being contacted by a company they’ve never heard of and being hassled for payment.

These concerns aren’t unfounded, but they are exaggerated. In reality, some factors will want direct communication with your customer to verify invoices, verify the assignment of the invoice, and make payment arrangements. However, this is more common in industries where factoring is more prevalent, and preserving customer relationships is a top priority for the factor.

Some factors create an arrangement where the factor has far less―and sometimes zero―direct communication with your customer. This can be done by opening a new bank account in your business’ name, with control of the account given to the factor. Your customers are notified of the new account information for payment and, if the factor contacts your customer, it presents itself as your billing department.

Time to Get Funding

Another important consideration is how quickly you can receive funding, and this may matter to you more than anything else if you need cash to make payroll or buy something essential for your business. With factoring financing, you can qualify within two to seven days and be funded in one to three business days after that. The exact funding speed will vary by factor.

Recourse vs Nonrecourse Factoring

One of the most important concepts to understand when considering invoice factoring is recourse factoring versus nonrecourse factoring. Recourse factoring means the factor may collect payment from you if your customer doesn’t pay the invoice within a reasonable time after its due date. Nonrecourse factoring is when the factor accepts the risk that the customer won’t pay.

Recourse factoring can become problematic if you have already spent the money you received from the factor. Therefore only factor invoices to customers who pay on time. Fees can continue to accrue until they pay the factor, often creating a new cash flow problem. However, with nonrecourse factoring, even if your customer doesn’t pay the invoice on time, your business won’t be on the hook for it.

Some firms advertise nonrecourse factoring, but then they list several reasons an invoice can be exempt from no recourse. Other factors will offer partial recourse agreements. Small businesses should tread cautiously and read their entire contract carefully to make sure they understand what they will and won’t be responsible for if their clients don’t pay the invoice or pay the invoice late.

Spot Factoring vs Contract Factoring

Spot factoring allows you to sell and assign individual invoices to a factor. While this may seem ideal for your business, many invoice factoring companies prefer not to factor in this way. The application process and underwriting aren’t different from if you were to factor all of your invoices.

Contract factoring is far more common than spot factoring and is the preferred method of factoring for most business factoring providers. Typically, contract factoring requires a minimum monthly invoice volume be factored―usually $10,000 or greater―or requires that every invoice to a specific customer be factored.

Industry Familiarity

Factoring is an area in which industry familiarity matters. The industry you and your customers are in can affect your terms and cost. Some factors specialize in providing financing to specific industries. Conversely, some factors won’t provide financing to certain types of industries. Do your research and find a factor that understands the needs and norms of your industry.

Pros & Cons of Invoice Factoring

Some benefits associated with factoring financing include that there is generally no minimum credit score requirement, it’s a fast way to receive cash, and experts will handle your accounts receivables (A/R). Conversely, the factoring company may have direct contact with your customers, selling your invoices relinquishes a level of control, and factoring can be expensive.

Pros of Invoice Factoring

• Creditworthiness of your customers is considered: With invoice factoring, your customer’s creditworthiness is more important than yours. This means you’re able to get financing even if you have poor credit.
• You get to work with accounts receivable experts: A potential upside to invoice factoring is the ability to develop relationships with A/R management experts. Because this is what your invoice factoring company does daily, it has good accounts receivable management techniques.
• Provides a quick source of cash: Invoice factoring provides a quick source of cash. You can get approved within two to seven days and funded in one to three days. There are, however, other fast business loans you could consider. It’s always good to weigh your options.

Cons of Invoice Factoring

• Factor may communicate with your customers: You can expect your invoice factoring company to contact your customers, and the level of interaction will vary by provider. If your business is in an industry where invoice factoring is common, this may not be a problem.
• Cost is expensive: With invoice factoring, not only are the interest rates higher than with other types of financing, but there is also the potential for additional fees. It’s important to read your contract to make sure you understand the total costs involved with this form of financing.
• Your invoices are sold: A feature of invoice factoring is that you’re selling, or assigning, your invoices to the factoring company. While this gives you an immediate source of cash, you’re also giving up some control and will expose you to a blanket Uniform Commercial Code (UCC) filing.

Invoice Factoring Frequently Asked Questions (FAQs)

Do I have to give up customer control with invoice financing?

With invoice factoring, you need to give up some of your customer control to your invoice factoring provider. This is not the case with invoice financing. With invoice financing, your relationship with your customers remains unchanged. You’ll continue to bill and collect your invoices like normal.

How do businesses qualify for invoice factoring?

Unlike most short-term financing, which is based on the creditworthiness of your business, qualifying for invoice factoring has little to do with you. Because repayment is based on your customers paying their invoices, the ability of your customers to repay is the most important. The creditworthiness of your customers matters more than your credit.

What does a factoring company do if my customers don’t pay their invoices?

What happens in the event your customers don’t pay their invoices depends on the arrangement you’ve made with your invoice factoring company? With nonrecourse factoring, the factoring company is responsible if invoices aren’t paid because your customer filed for bankruptcy or is otherwise insolvent.

Will I be required to factor all of my invoices?

The arrangement you’ve made with your invoice factoring company determines if you have to factor all your invoices. With spot factoring, you get to pick the invoices you sell to the factor. Contract factoring, which is more common, requires a minimum monthly volume or sets requirements on which invoices you have to sell.

Bottom Line

Factoring financing can seem more difficult than getting a loan from a bank. However, what makes factoring financing complicated is also what makes it appealing. You can borrow money based on your unpaid customer invoices to meet your immediate cash flow needs. As long as your clients pay promptly, the cost of factoring is more affordable than many other short-term business loan alternatives.