Contract factoring is the solution small businesses use for long-term factoring agreements. A small business may contract to factor invoices for a particular project or from a particular customer for an extended period in exchange for paying a lower fee. This ensures the business can receive financing and reduces the research costs for a lender.
How Contract Factoring Works
A company that wants to factor its invoices for the duration of a certain project will sign a contract with a lender. This contract will typically include the number of invoices to be factored, the advance rate, factoring rate, and the penalty that will be imposed on the borrower if he fails to remit the agreed-upon number of invoices.
All current and future invoices are then assigned to the factoring company. From that point forward, the factoring company will make advances on the invoices to the business and then collect the invoices from the debtor on behalf of the business. At the end of the contract, the business is no longer required to factor every invoice related to the project with the factoring company.
Contract Factoring vs Spot Factoring
The difference between contract factoring and spot factoring is in both volume and duration. Spot factoring is when a company factors either a single invoice or a set of invoices at a single time. Contract factoring, on the other hand, is a longer-term agreement where a company agrees to factor all the invoices it gets from a certain project or during a specific time frame.
Who Contract Factoring Is Best For
Contract factoring is a common solution for small business owners in the construction, professional services, and healthcare industries. In construction, a project may last several years with invoices due at various stages of completion, making contract factoring for the project very effective. Government contract factoring also is common because the payments are predictable.
Pros of Contract Factoring
- Less expensive service: Most invoice factoring companies we reviewed offer higher advance rates and lower factor rates with contract factoring. Long-term contracts represent a lower risk for the factoring company and more evenly distribute the information discovery costs required for onboarding new customers.
- Guaranteed credit for a set term: Companies engaging in long-term projects want the peace of mind that credit will be available through the project, making contract factoring an ideal solution.
- Outsourced receivables department: While building a receivables department has advantages, outsourcing the work to a factoring company can free up the necessary resources to reinvest in operations.
Cons of Contract Factoring
- Long-term contracts with penalties: While a long-term contract ensures funding, it’s also inflexible and often results in penalties if broken. Small business owners should understand potential fees before signing up for contract factoring.
- Reduced financing flexibility: Factoring the invoices for a specific project may make other lenders more reluctant to offer short-term funding. That’s because assigning your invoices reduces your assets. Small business owners must evaluate any financing needs and ensure that factoring can meet them.
Contract factoring is a way for a company to get the continuous cash flow it needs to be able to grow. Unlike spot factoring, contract factoring includes a long-term contract and other obligations to which a company must adhere. But depending on the number of receivables a company intends to factor, contract factoring can also mean lower finance rates, and will almost always be, compared to spot factoring, the less expensive option.