Invoice Factoring - What Is It, How Does It Work, and Is It Right for Your Small Business
May 25, 2022
A diverse financing plan provides fuel to grow your small business. This is true under any circumstances. But it has become particularly critical in the complicated economic landscape of 2022. Having a broad array of options — like invoice factoring — represents a crucial element in protecting your startup's survival.
Facing higher costs due to inflation, rising interest rates, and supply chain shortages, many small businesses have had to turn to alternative financing options. Invoice factoring fits this category. In the right situations, this form of financing can provide an excellent way to protect your cash flow. Here, you’ll learn how factoring works and what pros and cons to consider as you think about your options.
What is invoice factoring?
Invoice factoring lets you get paid for sales you've already made. A factoring company gives you a cash advance for your pending invoices (taking a fee for the service).
The process is similar to invoice financing. Under that structure, you borrow money based on your outstanding invoices. In effect, you use the amount you're owed as collateral for a loan.
However, the process of invoice factoring has important differences. Yes, it also provides an upfront payment for your pending invoices. However, it doesn't constitute a loan.
Rather, the factoring company effectively purchases your outstanding invoices. The firm will then collect the amount owed, sending you the balance of your agreed-upon share. The factoring firm will then keep a portion of the cash to cover its fees.
How invoice factoring fits into your financing plan
Having funding options always makes good business sense. Cash represents the lifeblood of your business. And for startups, this crucial element is often in short supply.
One study found that less than half of small businesses (48%) have what they consider satisfactory funding. That means most startups spend much of their time scrambling for the cash they need to keep the doors open, while simultaneously looking to invest in growth. The more alternatives you have, the better.
Traditionally, small businesses have looked to fund operations through options like:
- Lines of Credit
- Credit Cards
- Equity Investors
Invoice factoring offers a helpful addition to this toolbox.
Beyond these evergreen benefits to factoring, the process has particular appeal during today's uncertain economic times. With inflation at multi-decade highs, supply chain challenges still weighing on costs, and labor expenses pushing higher, invoice factoring provides another way to protect your cash flow. Meanwhile, the prospects of higher interest rates could put other options, like loans, out of reach.
With inflation at multi-decade highs, supply chain challenges still weighing on costs, and labor expenses pushing higher, invoice factoring provides another way to protect your cash flow.
What are the pros and cons of invoice factoring?
Invoice factoring can add flexibility to your funding plan. However, like any financing alternative, it comes with benefits and drawbacks. Consider these pros and cons as you weigh your options.
Improve Cash Flow Visibility
You can't always count on customers to pay on time. In fact, the opposite is often true — you can bet a majority of your payments will come in late. According to one study, six out of 10 invoices are paid late, with the cash coming in six days late on average.
This dynamic can prove dangerous. What if a key customer gets behind just as a payroll comes due?
Invoice factoring gives you some visibility on this front. You can smooth out these bumps and ensure that you have cash in hand when you need it.
Expands Your Funding Options
We already looked at some of the other possible ways to raise cash or pay bills in a crunch. These include loans, credit cards, lines of credit, and equity investors. Depending on the situation, invoice factoring can offer significant benefits compared to these competing choices.
Unlike loans, the process doesn't muddy your balance sheet or add long-term liabilities. Compared to most credit cards, factoring offers a cheaper way to reach your goals. Meanwhile, you won't face the same credit scrutiny or drawn-out process to secure funds as you would when you want a line of credit. Finally, factoring won't add a new investor to your list of problems the way an equity sale would.
Like any service, factoring comes with an expense. These costs might be well worth it. However, you should consider the details before making any decisions.
The precise cost structure will depend on your particular factoring agreement. However, there are several types of fees that come into effect. Keep an eye out for:
- Origination fees
- Termination fees
- Monthly/weekly fees
The amount you can receive through a factoring deal has several limitations.
First, the factoring amount is based on your pending invoices. At the same time, the creditworthiness of your customers will play a role as well. As such, any factoring partner will want to delve into your invoice aging report — a formal breakdown of the length of time your pending invoices have been outstanding.
Meanwhile, there are particular limitations to consider. For instance, many factoring contracts come with something called a customer limit. This caps the percent that can come from any particular client.
Details to consider as you think about factoring
It's important to look at the broader picture as you develop a factoring plan. Even within this funding structure, you have choices to consider. Meanwhile, a little foresight can help you avoid bumps along the way.
With that in mind, here are a few tips to keep in mind:
Work with your customers
Partnering with a factoring company can complicate your relationship with your clients. Essentially, a third-party firm will now get involved in collections. You should consider this aspect as you move forward.
This doesn't have to create significant tension. However, communicating effectively with your customers will help avoid any negative consequences. Think about how you want to deliver the news to clients as you launch the factoring process.
Recourse vs. non-recourse factoring
Factoring involves receiving cash for pending invoices. However, for the process to work properly, you eventually need to collect on those outstanding sums. Who suffers the hit if collection efforts fail?
The answer to that question comes down to recourse or non-recourse factoring. Recourse factoring means the ultimate responsibility for collecting falls on you. If the client doesn't pay, you'll have to bear the financial cost.
In non-recourse factoring, the factoring company carries the risk. They will eat the cost of non-payment. However, this structure comes with higher fees, as the funding firm will need additional compensation in exchange for absorbing any collection failures.
Understand your factoring agreement
Your factoring agreement requires careful scrutiny. From the fee structure to the collections process, the fine print will largely determine whether the process represents a good fit for you. Go over the details carefully and understand their implications.
From the fee structure to the collections process, the fine print will largely determine whether [invoice factoring] represents a good fit for you. Go over the details carefully and understand their implications.
At the same time, shop around for the ideal factoring partner. Your experience with different companies could vary dramatically. Take your time to find a firm that fits your goals.
Looking for cash in uncertain times
Invoice factoring can add flexibility to your funding plans. This is especially true in times of uncertainty. As you search for much-needed cash, invoice factoring could represent a suitable option for your small business.
However, you can't rush into a factoring deal. There are pros and cons to contemplate. The information provided here will give you a good start as you ponder if this is the right financing option for you.