Invoice factoring is a type of accounts receivable financing that converts invoices due within 90 days into immediate cash for your small business. The factoring company will typically pay out two installments for your invoice: an advance of 80% of your invoice and the remaining 20% (minus fees) after the invoice is paid.
What Is Invoice Factoring?
Invoice factoring provides short-term capital in exchange for selling and assigning invoices to a factoring company (referred to as a factor). The factor advances you 80% of your invoice value. Once the invoice is paid, the factor pays the remaining 20% (minus fees).
Though similar, small business invoice factoring is not the same thing as invoice financing (or accounts receivable financing), although the terms are often used interchangeably.
Invoice financing is more streamlined, easier to use, and doesn’t require the assignment of invoices like factoring does.
Invoice factoring is typically a solution for short-term cash flow problems. It is frequently used as a way for businesses to simplify their cash flow conversion. Factoring financing is most often not used for big capital investments.
How Invoice Factoring Works in 5 Steps
With invoice factoring, your account receivables (invoices) due within 90 days are sold to a third party. It’s a quick and easy immediate cash source. You’ll receive an initial advance of approximately 80% of your invoice upfront. Once your customer pays the invoice, you’ll receive the remaining 20% (minus fees).
The five steps in invoice factoring are:
1. Invoice Your Client
Once you have provided products or services to your B2B or B2G customer, you issue an invoice for them to pay you. To qualify for small business invoice factoring, these invoices must be payable within 90 days.
2. Sell & Assign the Invoice to a Factor
Prior to being able to receive factoring financing, you will need to find a factoring company you want to work with and then go through the application process. The factor will determine if you meet the eligibility criteria to receive financing and conduct due diligence on the customers you’re invoicing to see if they are good credit risks.
If the factor decides to approve your business based on that research, you and the factor will sign a financing agreement. The agreement will set an initial maximum dollar amount that you can borrow, which is the maximum factored amount outstanding at any given time.
Once you have a factoring relationship established with a factor, you will sell them all of your outstanding invoices. When you submit an invoice, the factor will review the invoice for eligibility and issue the advance.
3. Factor Issues an Advance on the Invoice
After submitting your invoices, the factor gives you an initial advance based on the agreed-upon advance rate. The advance rate is generally around 80% of the value of the factored invoice. The amount of your advance depends on the size of your transaction, your industry, and other risk parameters.
At this point, the factor may also send out a “notice of assignment” to the clients you have chosen to factor, or they may ask you to do so. The notice of assignment states that your company has assigned the factor as the entity to receive future payments for invoices you issue them. All payments will go to a lockbox account (like a designated account for the factored invoices to be paid), which is set up by the factor.
Some industries are more accustomed to invoice factoring than others. Trucking and shipping companies commonly use freight factoring, and staffing companies and recruiting agencies use staffing factoring. In industries where factoring is common, telling a client you’ve assigned their invoice might not be a problem. If factoring isn’t common in your industry, you might benefit from invoice financing, which doesn’t require invoice assignments.
4. Client Pays the Factor
Your client will pay the factor within 90 days according to the terms of the invoice. The factor will typically handle the collection on all the invoices you assign to them. Generally, the factor tries to follow your history of collection techniques, unless the client is past due. This means there is generally no negative impact on your customers.
5. Factor Forwards You the Remaining Balance (Minus Fees)
After receiving payment from your client, the factor will give you the remaining balance of the invoice, called the reserve amount, minus their fees. For example, if your advance rate was 80% with a monthly factor rate of 3%, and your customer repaid within 30 days, the factor would pay you the remaining 17% at this point.