Invoice Factoring: A Complete Guide for Small Businesses
About 225,000 new small businesses are established every quarter in the United States. While those small businesses may fall in a wide range of industries, from construction to beauty salons, they all share one thing in common — all require a steady flow of working capital. A common challenge many small businesses face is the delay between when invoices are paid and when new inventory needs to be purchased. Invoice factoring is a way for small business owners to take out a loan against unpaid customer invoices–it’s typically best for businesses whose customers do not pay for goods right away but need cash on hand to run their business effectively.
What is invoice factoring?
Invoice factoring is a way for business owners to quickly unlock funds from pending invoices for operational expenses as well as growth opportunities. Simply put, invoice factoring is when a business sells its accounts receivable to an invoice factoring company in exchange for upfront cash. With invoice factoring, you get paid by a factoring company, and the factoring company then gets paid directly by your customer.
This allows you to turn your accounts receivable into cash, rather than waiting as long as 90 days for customers to pay. Invoice factoring companies typically pay you in the following two installments:
The advance, which is an upfront payment of 70 to 90 percent of the invoice
The remainder of the loan amount (minus applicable fees) after the customer has paid the outstanding invoice
How does factoring receivables work?
Let’s imagine that Tiffany runs a residential staging company in which she’s hired by real estate agents to furnish and prep homes that are for sale. When Tiffany receives a staging assignment, she buys or rents furniture, artwork, and other decorations to give the property a specific look and feel which makes it more attractive to potential buyers.
While Tiffany charges an initial consulting fee, she generally gets paid on a monthly basis. However, every time a new client requests a staging, Tiffany needs to procure additional materials — and that requires a significant amount of upfront cash that she won’t see in her bank account for another 30 days.
By factoring receivables, Tiffany uses an invoice from a previous job and gets an advance rate of 70 to 90 percent of the total invoice within 24 hours. With those funds, she can avoid a cash crunch and keep a steady flow of capital to cover staging items and moving fees.
Invoice factoring: the pros and cons
Let’s review some important pros and cons when it comes to invoice factoring.
The pros
Fast access to cash: Turning down a big order from a customer and letting the competition snag that business is never ideal. Being able to meet the necessary financial obligations to get to work right away is a major plus for invoice factoring, with Swift SBF in as little as one to three business days.
Easier approval: Many banks are hesitant to lend to small businesses in general, much less those with less-than-excellent credit. With invoice factoring, your credit score tends to not even be a factor — lenders are primarily concerned with the creditworthiness of your customers (since your customers are technically responsible for paying back what you borrowed) and outstanding invoices. So, if your credit, or time in business, is preventing you from securing other small business loans, invoice factoring may be the right option to secure working capital.
Spend your time growing your business (rather than chasing down clients): When you first set on your quest to become your own boss and make your entrepreneurial dreams a reality, you sure didn’t think you would spend a good part of your day sending emails like “February Invoice” and following up on partial payments from clients. Having the ability to tap into much-needed cash flow empowers you to focus on your real objectives: growing your business.
The cons
Factoring rates and fees tend to be higher than those of traditional business loans: Fast cash comes at a cost. Compared to other small business loans, invoice factoring often costs more and is accompanied by additional fees. The cost of borrowing money is determined by the factor rate (also referred to as a “discount rate” or “factoring fee”), which ranges from 0.5% to 5% (per month) of the invoice amount advanced or total invoice amount. The factor rate can be charged as a one-time fee, or on a weekly or monthly basis, depending on the lender and terms determined. Your rate will largely be determined by the number of invoices (and dollar amount) you’re planning to factor — so as a general rule of thumb, the more you sell, the lower your rate. As an example, let’s say you’re charged a factor rate of 4% per month on the total invoice amount. This means that from a $10,000 invoice, you’d only see $9,600 — and that’s if your customer pays within one month. Factors may also charge an initial one-time fee to get started, monthly maintenance fees, invoice processing or advance fees, early termination fees, or even monthly minimum fees.
Recourse factoring could land you in a tricky situation: There are two types of invoice factoring: recourse and nonrecourse. Recourse factoring is much more common and makes you, the business owner, liable for invoices that go unfulfilled. So, if you sell a $25,000 invoice to a factoring company, and your customer ends up failing to pay, you’ll need to muster up the funds.
You may not have the option to pick and choose which invoices to sell: While some lenders offer spot factoring (the ability to choose which invoices to factor), some factoring companies may require you to sell all of your outstanding invoices. If you have a slow-paying customer — or multiple — this could end up hurting you more than helping you.
Is invoice factoring right for you?
It all boils down to two key questions:
Using the example above, would you be willing to give up 8% (likely more with fees) of an invoice to access the other 92% much faster?
If yes, are you ok with receiving only 80% now and 20% (minus fees) once your client pays?
In general, you may only want to factor an invoice if obtaining working capital right away outweighs its high cost.
What qualifications does a factoring company require?
There are over 700 factoring companies in the U.S and the list of requirements often vary based on the company. Here are the most common requirements that you may come across:
B2B revenue model: You invoice businesses or government entities, not individuals
Invoices payable within 90 days and free of any lien
Accounts receivables aging report
Accounts payable aging report
Personal tax returns for last three years
Business tax returns for last three years (if available)
Financial statements (balance sheet, income statement and cash flow statement) dating back three to five years
Proof of ownership of business
Completed application form
What is the difference between invoice financing and factoring?
The key difference between invoice financing and invoice factoring is who is responsible for collecting payment from clients.
With invoice financing, you’re borrowing against your accounts receivables with these outstanding invoices serving as collateral. An invoice financing company lends you cash upfront and, upon receiving payment from your client, you pay back the lender the loan plus interest and applicable fees. Your business remains responsible for collection and continues to manage the relationship with your clients.
With invoice factoring, you’re selling your outstanding invoices, meaning the lender essentially buys the accounts receivables from you and takes over collecting from your client. The factor advances you a portion and sends the remaining balance (minus fees) after collecting from your client.
Another thing to keep in mind when comparing invoice factoring and invoice financing is the payment structure:
With invoice financing, you can be advanced as much as 100 percent of the outstanding invoices, but will be required to pay back the lender on a weekly basis over a set period of time — typically 12 to 24 weeks.
With invoice factoring, you’re advanced 70 to 90 percent of the invoice and repayment is based on how long your customers take to pay off the outstanding invoices.
How much does factoring invoices cost?
Let’s explore the following scenario:
$25,000 invoice from a client that takes two weeks to pay
80% advance and 20% reserve (minus fees) at client payment
3% processing fee
2% factor rate per week
$5 ACH fee for every time a factor issues you a payment
In this scenario, you would receive $19,995 [($25,000 x 80%) – $5 ACH fee] in a few days.
Your customer pays the invoice two weeks later. After subtracting the 3% processing fee ($750), 2% factor rate per week ($1000), and $5 ACH fee, the factor pays you the remaining $3,245. In the end, you only would see $23,240 from that original $25,000, costing you $1,760 with an effective APR of 183.04%.
Invoice factoring vs. term loans
Invoice factoring is best used to cover very short-term capital needs. With weekly factor fees and target collection periods of 90 days and under, invoice factoring is ideal for covering operational costs.
On the other hand, term loans are often used to finance larger growth investments which will lead to an increase in your bottom line. Common uses cases for term loans include opening a second location, hiring additional staff, or refinancing high-interest debt from credit cards.