Invoice factoring is a type of business financing that allows a company to receive advances on unpaid invoices. Those unpaid invoices are assigned to a factoring company, which then offers your business an advance of approximately 80% of the invoice upfront.
The customer repays the factoring company. Once the invoice is satisfied, the remainder of the invoice, minus fees, is distributed to your company. Invoice factoring can help your business with cash flow, as you don’t have to wait for customers to pay unpaid invoices. However, fees on invoice factoring can be much higher than other forms of business financing.
Small businesses needing to factor invoices of up to $10 million can do so with FundThrough, which offers a fast application and an invoice assignment process that can sync seamlessly with your QuickBooks account. The application process is simple and entirely online. Check out FundThrough’s website for more information.
Types of Invoice Factoring
Invoice factoring is a type of accounts receivable (A/R) financing. It is an alternative to working capital loans to provide short-term funds to your business.
Before discussing how invoice factoring works, it is essential to understand the different types of factoring available. Here is a list of the types of factoring available from invoice factoring companies:
- Recourse factoring: Your business is 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: Your business isn’t liable for unpaid invoices; however, it is only available to businesses with numerous invoices
- Spot factoring: A common form of factoring for small businesses because business owners can factor specific invoices as needed as opposed to all invoices
- Contract factoring: 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: An uncommon type of factoring, this is a 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: 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
How Invoice Factoring Works in 7 Steps
Step 1: You Compare Invoice Factoring Terms, Rates & Fees
Invoice factoring is a good working capital solution for businesses of varying sizes and ages, as long as your business has qualifying invoices. You can qualify for invoice factoring if invoices are due within 90 days and have no serious tax or legal problems. Some factoring companies will work with startups, while others require at least three months of business operations.
Qualifying for invoice factoring is often easier than qualifying for long-term financing. You typically qualify if you have business-to-business (B2B) or business-to-government (B2G) invoices due within 90 days and no recent tax or legal issues.
While credit scores and debt service coverage ratios (DSCRs) can be significant hurdles for other types of financing, they’re less often issues with invoice factoring. Some factoring providers don’t even check your credit score.
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Step 2: You Consider Recourse vs Nonrecourse Factoring
Recourse factoring can become problematic if you have already spent the money you were advanced. It’s best to only factor invoices on those customers who pay on time. Fees can continue to accrue until you or your delinquent customer pays the invoice, often creating a new cash flow problem.
However, with nonrecourse factoring, your business won’t be on the hook for it even if your customer doesn’t pay the invoice on time. If you’re interested in pursuing nonrecourse factoring, see our list of the leading nonrecourse factoring companies.
Read your agreement carefully before signing. Some firms advertise nonrecourse factoring but then list several reasons an invoice may be exempt. Others will offer partial recourse agreements. Read your entire contract carefully to understand what you will and won’t be responsible for if clients don’t pay the invoice or pay the invoice late.
Step 3: You 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 4: You Sell & Assign the Invoice to a Factoring Company
Before receiving invoice factoring financing, you must find a provider you want to work with and go through the application process. Our roundup of the best invoice factoring companies contains our recommendations.
The factoring company will determine if you meet its eligibility criteria to receive financing. It’ll also conduct due diligence on your invoiced customers to see if they are good credit risks.
If the factoring company approves your business based on its research, 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.
One of these fees, the discount rate, is determined in part by the creditworthiness of your customers. When possible, it’s best to use customers with good payment histories for invoice factoring.
Step 5: Factoring Company Issues an Advance on the Invoice
After submitting your invoices, the factoring company gives you an initial advance based on the agreed-upon advance rate. On average, the advance rate is 80% of the value of the invoice, also known as the borrowing base. The advanced amount will depend on your transaction’s size, industry, and other risk parameters.
The factoring company 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. All payments will go to a designated lockbox account, which the factoring company sets up.
Some industries are more accustomed to invoice factoring than others. Trucking and shipping companies often use freight factoring. Factoring is also common in construction. Telling a client you’ve assigned their invoice might not be a problem in these industries. If factoring is uncommon in your industry, you might benefit from invoice financing, which doesn’t require invoice assignments.
Step 6: Your Client Pays the Factoring Company
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’ll try to follow your history of collection techniques unless the client is past due.
Step 7: Factoring Company Remits the Remainder, Minus Fees
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. If your advance rate was 80% with a monthly factor rate of 3% and your customer repaid within 30 days, the factoring company pays you the remaining 17%.
Advantages of Invoice Factoring
- The creditworthiness of your customers is considered: Because the factoring company is concerned with your customers’ ability to repay invoices, it is the customers’ creditworthiness that will be considered instead of your business credit. This can be helpful for companies with lower credit scores, as bad credit loans are often very expensive.
- You work with accounts receivable experts: Because you are working with a company specializing in invoice factoring, you are working with accounts receivable experts who can help get your invoices paid. This is critical for very small companies that may have limited accounts receivable resources.
- You get a quick source of cash: Invoice factoring allows you to get immediate cash flow to cover short-term financial needs. Approval can be faster than some lending types, and you don’t have to wait for invoices to be paid, which can take 90 days or more.
Disadvantages of Invoice Factoring
- The factoring company may communicate with your customers directly: While it is helpful that the factoring company helps you collect unpaid invoices, many factoring companies will notify customers that they are handling your invoices. This may make customers less trusting of your business, as it introduces a third party into your business relationship.
- The fees and overall cost can be high: Because fees increase the longer it takes to collect the invoice, invoice factoring can be a very expensive form of credit if customers don’t pay on time. In addition, there is a history of shady invoice factoring companies charging customers with hidden fees. Choose a reputable factoring company to avoid this risk.
- Your customers’ poor credit may derail factoring: While it is good that businesses with lower credit scores don’t have to rely on their own credit score to get factoring, the other side of that equation can be a problem. If the companies you invoice have poor credit, you may not be approved for invoice factoring.
Alternatives To Invoice Factoring
While invoice factoring is great for companies with outstanding invoices needing immediate cash flow, it might not be the right type of financing for your business. Consider these other types of financing for short-term financing needs:
- Short-term business loans: These have a quick application process, simple repayment plans, and fast funding. They will have lower APRs than invoice factoring contracts. Check out our top-recommended easy business loans.
- Business lines of credit: These allow business owners to draw against an established credit limit as needed rather than receiving the full loan amount upfront. Interest is charged on the amount used, and borrowers repay in installments.
- Equipment loans: These are fixed financing to purchase or refinance vehicles and heavy equipment. The purchased collateral secures the loan. Our lists of the best equipment loans for startups and best equipment loans for bad credit can help you find a lender.
- Home equity line of credit (HELOC): This uses the equity in the business owner’s property (usually a primary residence) to take out a loan or line of credit. The business owner will need to have equity in the residence, a debt-to-income (DTI) ratio of 50% or lower, and a credit score of at least 650 or above. For guidance, refer to our article on how to use a HELOC to finance your business.
- Business credit cards: These help with cash flow management and can offer perks and rewards for the business. They are 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: 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.
Before applying for any financing, check out our guide on how to get a small business loan.
Invoice factoring is an excellent option for businesses with outstanding invoices but need cash flow sooner than the invoice will be paid. If your clients pay on time, invoice factoring can be more affordable than some short-term loan options. However, it is critical to understand the fees involved with invoice factoring. Compare the fees paid with invoice factoring to other short-term lending options and choose the most affordable option for your business.