The basic idea
Many businesses that sell to other businesses do not get paid right away. They deliver the product or complete the work, send an invoice, and wait for payment on terms such as net 30, net 60 or longer. Meanwhile, they still need to pay employees, suppliers and overhead.
Invoice factoring addresses that gap. Instead of waiting, the business sells its outstanding invoices to a factoring company, often called a factor. The factor advances a large percentage of the invoice value up front, collects payment from the customer, and then sends the business the remaining balance minus its fee.
Factoring is technically a sale of receivables rather than a traditional loan, although its cost and contract terms should be evaluated just as carefully as any financing.
How the process works step by step
First, the factor reviews your business and, importantly, your customers. Because your customers are the ones who will pay the invoices, their creditworthiness is a major part of the decision. This is why factoring is often available to younger businesses or those with weaker owner credit.
Once approved, you submit invoices for completed work. The factor verifies them, which may include confirming with the customer that the work was delivered and the invoice is valid. It then advances a percentage of the invoice amount, known as the advance rate, to your bank account.
Your customer pays the invoice to the factor, usually through a payment address or account the factor controls. When payment arrives, the factor releases the reserve, which is the portion it held back, minus its fees.
Some arrangements require you to factor all invoices from certain customers, while others let you choose which invoices to factor. Ask about minimum volume requirements and contract length before you sign.
How factoring fees work
Factoring fees are commonly expressed as a percentage of the invoice value for a period of time, such as a rate per 30 days, or as a tiered fee that increases the longer the invoice remains unpaid. The structure varies by factor, so read it closely.
Because the fee is tied to time, the cost depends heavily on how quickly your customers pay. A customer who pays in 25 days costs less to factor than one who takes 75 days. When you compare offers, model the fee using your customers' actual payment history rather than the stated terms on the invoice.
Look for additional fees as well, such as application fees, due diligence fees, wire or ACH fees, monthly minimums, lockbox fees and termination fees. These can add meaningfully to the total cost. Converting the total cost into an approximate annualized figure can help you compare factoring with other options such as a line of credit.
Recourse vs. non-recourse factoring
In recourse factoring, if your customer does not pay the invoice, you are responsible for buying it back or replacing it with another invoice. Recourse factoring is common and generally less expensive because the factor takes on less risk.
In non-recourse factoring, the factor absorbs the loss in certain situations, most commonly when the customer cannot pay because of insolvency or bankruptcy. Non-recourse arrangements usually cost more. Pay close attention to the definitions in the contract, because non-recourse protection often does not cover disputes over the quality of the work, short payments, or a customer that simply refuses to pay.
Customer notification and relationships
In most factoring arrangements, your customers are notified that invoices have been assigned to the factor and are asked to send payment to the factor. This is a standard practice in many industries, such as trucking, staffing and manufacturing, and many customers are familiar with it.
Still, the factor's collection approach becomes part of your customer experience. Ask how the factor communicates with customers, how it handles late payments, and whether you will be consulted before any escalation. Some providers offer non-notification arrangements, though they tend to have stricter qualification requirements.
Who factoring is a good fit for
Factoring tends to fit businesses that invoice creditworthy commercial or government customers, have long payment cycles, and are growing faster than their cash allows. Trucking, staffing, manufacturing, wholesale distribution and B2B service companies commonly use it.
It is generally not a fit for businesses that sell primarily to consumers, since there are no business invoices to factor. It may also be a poor fit if your invoices are frequently disputed, if your work is billed in progress stages that are hard to verify, or if your margins are too thin to absorb the fees.
Factoring also places a lien on your receivables. If you already have a bank line of credit secured by receivables, you will need to coordinate with that lender.
Alternatives to consider
Accounts receivable financing, sometimes called invoice financing, lets you borrow against receivables while keeping collections in house. A business line of credit may cost less for established businesses with strong financials. Some businesses also negotiate shorter payment terms or offer early-payment discounts to customers.
If you are considering factoring, compare at least two proposals using the same set of invoices and realistic payment times. A WellRounded Capital advisor can help you evaluate factoring alongside other cash flow options.