82% of small and medium-sized businesses fail because of cash flow problems. And while there are many factors that can impact cash flow, invoices or accounts receivable account for a fair share. Invoice, or more specifically, unpaid invoices, can be a big problem for small business owners.
Fortunately, many small business owners can manage gaps in cash flow. From small business loans and lines of credit to purchase order financing and cash advances, there are many ways you can weather gaps in cash flow. However, if you have net 30, net 60, or net 90 terms with customers, you may want to consider invoice factoring.
What does invoice factoring mean?
In the simplest sense, invoice factoring, also referred to as accounts receivable factoring, is the sale of your outstanding invoices to a third-party payer in exchange for cash to cover the cost of day-to-day operations or other expenses. Though often listed among business financing options, true invoice factoring is not a loan. Instead, it’s a finite transaction that results in the transfer of good — i.e., invoices — from your business to the factoring company.
As a result of this transaction, the factoring company takes ownership of collection efforts. This is important to note as it’s the defining characteristic separating invoice factoring and invoice financing, the difference of which we’ll cover below.
How does invoice factoring work?
As with many other small business funding solutions, the invoice factoring process can vary from company to company. Generally, it begins with the application process.
Applying for factoring is similar to applying for any other type of funding. You’ll need to provide basic information about your small business, though the factoring company will take far more interest in the quality of your unpaid invoices.
If approved for a factoring agreement, the process will begin and the factoring company will issue a cash advance for a percentage of the agreed upon amount — usually between 80% and 90%, though it can vary based on the company you choose and the quality of invoices to be factored.
The remaining portion of the balance, minus any fees, will be paid to you in a subsequent installment. In some cases, factoring companies will send over the outstanding funds as invoices are paid. Others will batch them.
But what if your customers fail to pay the invoice? That depends on the type of factoring you’ve agreed to: recourse factoring or non-recourse factoring.
Non-recourse factoring contracts involve the factoring company assuming the risk for the invoice. If the client fails to pay the invoice, you won’t be held financially responsible. This also means the factoring company will charge more in fees for the assumed risk, but it may be worth the price.
Recourse financing is just the opposite – your company would be on the line if the invoice is unpaid. Many factoring companies will provide credit checks on your debtors before you pull the trigger, and you’ll often save more in fees than you would with the non-recourse route.
Because your recourse obligations, as well as the process, rates, fees, and terms can vary, it’s important to thoroughly read and understand your factoring agreement so you can manage your business finances accordingly.
Invoice factoring rates & fees
One of the most confusing parts of the factoring equation is cost, particularly the rates and fees.
Rates and fees vary based on a variety of factors, including the number of invoices you plan to factor and the creditworthiness of your customers, but you can typically expect a factoring fee between .05% and 4%.
Another consideration to keep in mind is how the lender will assess fees. Generally, they do so using a tiered rate schedule, where fees are assessed based on how long it takes for the client to pay.
For example, if you plan to factor $20,000 worth of invoices, and the fee is 2% per month, you would pay $400 in fees if the unpaid invoices were paid in the first 30 days, $800 if they paid within 60 days, and $1,200 if they paid in 90 days.
Some factors also apply a flat fee. In this case, you can expect to pay the same amount in fees regardless of whether the customers pay in 30, 60, or 90 days. For instance, if you planned to factor $20,000 worth of outstanding invoices and the factor applied a 5% fee, then you’d pay $1,000 in fees, whether the invoice was paid in 30 days or 90 days.
In addition to the basic factoring rate, you may also be required to pay additional fees, though these also will vary by company. Keep an eye out for application fees, servicing fees, processing fees, ACH fees, and monthly minimum fees.
Invoice factoring vs. invoice financing
If you’re considering invoice factoring, it’s also a good idea to become familiar with invoice financing. Though they aren’t identical, you’ll find that the two terms may be used interchangeably.
Instead of selling your invoices or account receivables, as is the case with factoring, invoice financing allows you to borrow against outstanding accounts. Once your client(s) pay you, you’ll repay the lender the agreed upon value plus and fees or interest.
The two terms are often used interchangeably by some — incorrectly so. Though they both leverage your invoices, invoice financing or accounts receivable financing allows you to borrow against outstanding accounts. Once your customer(s) pay you, you’ll repay the lender the agreed upon value plus any fees or interest. Financing does not result in a sales transaction.