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Bert Goldberg Executive Director, International Factoring Association View bio
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Stephen Denis Executive Director, Small Business Finance Association View bio

This guide was written by

Jessica Sillers

Cash flow is one of the biggest concerns for small businesses, and banks aren’t always willing to hand out typical loans to a company that is already short on cash. If you relate to this struggle, you may have wondered about working with an “invoice factoring company,” often called simply a “factor.” A factor will buy the invoices owed to your business at a discount and put an advance in your account in a few days, instead of weeks or months. But quick cash comes at a cost. This guide will show you how to protect your business while working with a factor for short-term financing.

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How Invoice Factoring Works and How to Protect Your Money

Let’s say you run a catering business where you provide three-course dinners for corporate events. Things are going well: You have a pool of recurring clients, a staff of cooks and servers and plans to expand your services into another city. The only problem is that these corporations expect 60-day payment terms on their contracts, and this hurts your ability to pay your employees on time or pounce on a new business opportunity. Invoice factoring may be a solution.

Invoice factoring can be a good option if your business doesn’t qualify for a traditional bank loan, or if you don’t have time for a lengthy application process. Factors will check your credit (they may or may not investigate your clients’ creditworthiness, too). They are often more forgiving than banks, however, which tend to be more conservative in their lending. Factors also tend to process applications quickly. After all, they cater to businesses whose primary concern is a lagging cash flow.

The Players

There are three players involved in an invoice factoring arrangement: the business, the customer and the factor.

1

The business sends an invoice to the customer but needs the money faster than the payment terms allow (many B2B clients pay on 30-, 60- or even 90-day terms).

2

The business sells the invoice to the factor in exchange for an advance on the receivable funds (a 70-90 percent advance is common).

3

From this point, the factor interacts with the customer to collect the invoice.

4

Once the customer pays, the factor delivers the balance of the invoice to the business, minus its fee.

The Invoices

bill Factors make money by collecting a percentage of the invoices they buy. Depending on the business’s creditworthiness, size of the account and length of time it takes to collect the invoice, typical rates range from around 1.5-4.5 percent. Factors may also charge transfer Automatic Clearing House (ACH) fees, closing fees, lien search fees or fees for “due diligence” costs such as background checks. If you’re considering working with a factor, compare a few offers if possible. Is one factor charging an ACH fee that’s inflated five or 10 times over a traditional bank rate? Does a factor pressure you by offering to waive a closing fee if you sign a contract by a certain date? A factor that dangles a 1 percent rate but adds meaningless or exorbitant fees should raise red flags for any business owner.

The Cost

coin Many sites report high APRs with invoice factoring companies (popular factor Bluevine is reported to have an astronomical 17 -60 percent APR). Some experts, however, argue that comparing a factor’s rate to an APR is a flawed approach.

“Both sides are true,” explained Bert Goldberg, executive director of the International Factoring Association (IFA). “You could compute the rate and it would come to that range, but…it’s difficult to say it’s an APR because they’re buying an invoice.”

Many people multiply a factor’s 30-day rate by 12 and use that number to assess the cost of working with the factor for a year. A factor’s fee is based on a particular transaction, though, not interest on a long-term loan. It’s highly unlikely that a factor will charge you their 30-day rate for an entire year while they attempt to chase down a slow-paying client over one invoice. More realistic scenarios are that either:

1

The client pays on time, and you’re charged the factor’s rate based on the client’s 30-, 60- or 90-day payment terms;

2

The client pays late, and you’re charged an extra fee (roughly 1 percent for every 10 days an invoice is overdue is fairly typical); or,

3

If you have a recourse factoring contract and a client isn’t paying, the factor may hold you accountable to buy the invoice back.

If you need a faster cash flow to take advantage of early payment or bulk order discounts from suppliers, you might recoup some cash. Ultimately, though, the main benefit of invoice factoring is flexibility, not savings. Businesses that need to be as agile as possible for fast growth – and that lack other options — reap the most rewards from this alternative financing option.

Which Is Better: Invoice Factoring or Accounts Receivable Financing?

Invoice factoring is often lumped interchangeably with other services, like invoice financing or accounts receivable financing. These services have a lot in common, but there are a few important distinctions. With invoice factoring, the factor owns the invoice, and it’s typically its responsibility to collect payment. Rates are often higher because the factor takes on more liability. The upside is that invoice factoring is more flexible, allowing businesses to “spot factor” or select individual invoices rather than having to submit all the accounts receivable for a particular client.

An accounts receivable financing service offers a business an advance loan on an invoice. The business submits accounts receivable as collateral for the loan. This service tends to be cheaper than invoice factoring because there is collateral. It can also be easier for a business to transition from accounts receivable financing to a traditional bank credit line.

How to Choose an Invoice Factoring Company

If invoice factoring seems right for your business, follow these steps to find a factor that can help your business develop:

Ask for a month-to-month contract if possible.

Signing a 12-month contract and then finding you only need six months of invoice factoring services can be frustrating.

Maintain the right to contact your customers to collect payment if you can.

Some factors are fine with business owners handling communication with clients over invoices. Others insist that they be the ones to connect with customers to get payment. Your clients probably prefer dealing with you. Also, any time a third party contacts your customers, there is a risk of unethical behavior. Reputable factors also work directly with customers, so this isn’t an automatic deal breaker, but it’s worth asking to retain control over your customer relationships.

Use invoice factoring for individual invoices, rather than an entire client account.

Spot factoring offers you greater flexibility and can save you money.

Understand the difference between a recourse and a non-recourse loan.

A recourse loan keeps you on the hook to pay back assets if a customer fails to pay an invoice. Ideally, find an invoice factor that won’t require a personal guarantee from you.

Watch for hidden fees, penalties or costs that don’t add up.

Are there inflated charges for wire transfers? Is there a recurring lien search fee?

Don’t get taken in by “teaser” rates.

Remember, something that looks too good to be true often is. Chances are, a factor will make up a rock-bottom rate elsewhere. Calculate all costs to make sure you’re not better off with a higher base rate but fewer extra fees.

While many invoice factoring companies are reputable, businesses that need quick cash can also be a potential target for shady companies. Compare multiple offers and always read contracts carefully, including understanding how you could incur a penalty; better yet, have your attorney read them. Steer clear of any contract that includes charges that don’t feel right.

Pros and Cons of Invoice Factoring

Invoice factoring is handy for some businesses, but this isn’t a one-size-fits-all financing solution. Consider the pros and cons carefully to decide whether your business will benefit from working with a factor.

Invoice Factoring Pros
  • Quick access to cash.

    A factor can give you an advance on receivables in days, not months.

  • Growing your business faster.

    “There’s a huge difference between a small business and a consumer,” according to Steve Denis, executive director of the Small Business Finance Association. “They’re trying to use this money to make money, not just pay bills.”

  • High approval rates.

    New businesses that haven’t built the credit to qualify for a traditional loan may still be approved by a factor.

  • Lower liability.

    You’re selling the invoice, so you won’t have to use your personal credit or put up business assets as collateral.

  • Low minimum level of receivables.

    Several major factors, such as Bluevine and Capital Plus, don’t require monthly minimums at all.

  • Flexibility.

    Factors may offer low minimums, spot factoring, month-by-month contracts or other terms to help you customize your plan based on your business needs.

  • Saving time.

    For some businesses, having a factor handle collecting payment from clients may be a time-saving perk.

Invoice Factoring Cons
  • Loss of control over invoices.

    Customers may get nervous when a third party collects debts instead of you. (You may be able to negotiate more control with a factor).

  • Unexpected or higher fees.

    If an invoice becomes delinquent, for example, you may face daily rate increases until the factor is able to collect the funds. Fees on money transfers or credit checks may be much higher than a more traditional financing option.

  • Risk of unethical factoring providers.

    Anytime an industry serves people who need quick cash, you’ll find some predatory players. Do your homework to avoid unscrupulous factors.

  • You may be held responsible if a client doesn’t pay an invoice.

    This can be a big problem if you’ve already spent the advance.

  • Customer service reputation.

    Some clients may perceive your use of a factor as a sign that your company is in financial trouble or be annoyed at dealing with a third party.

How to Qualify for Invoice Factoring

As we mentioned earlier, the invoice factoring application process tends to be very simple compared to a traditional bank loan. Still, factors often have some bare-minimum requirements to take on a business. Some common requirements include:

  • You run a business

    Some factors may need to see proof in the form of LLC or incorporated structure.

  • You meet the minimum length of business operation

    A factor may require that you’ve been in business for a minimum number of months.

  • You have business or government clients

    B2C businesses (that is, retailers) almost always get paid at the time of sale, so invoice factoring usually doesn’t make sense for their business model.

  • Your clients have a good credit score

    Some factors, although not all, require businesses to meet a minimum credit score (Bluevine works with businesses with a 530 minimum score). Generally, though, your client’s credit matters more than yours. The factor is betting on your client’s ability to pay.

  • You meet the minimum revenue threshold or profit margin

    Not all factors require a business to make a minimum level of revenue, but it’s possible. A profit margin of around 15 percent will satisfy many factors.

  • You don’t have any liens or other holds on your invoices

    The factor needs to have first rights to the receivables to buy them from you. Bankruptcy will likely also disqualify you from entering an invoice factoring agreement.

Expert Q&A

Bert Goldberg, executive director of the International Factoring Association, is a primary spokesperson and expert on the factoring industry. Steve Denis, executive director of the Small Business Finance Association, represents various alternative lenders that finance small businesses.

What types of businesses can benefit the most from invoice factoring?

bert

Goldberg: Factors work with just about any type of business that sells to other businesses. Probably some of the most common are transportation, temp agencies [and] manufacturing.

denes

Denis: Say you’re a restaurant and need to replace an industrial oven. You need money faster than a traditional loan can close. Typically, business owners don’t feel comfortable using their personal credit.

How much is a typical invoice factoring fee? Are there any hidden fees that applicants should be aware of?

bert

Goldberg: A factor’s fees are going to be similar to a credit card’s fees, 3-5 percent of an invoice.

denes

Denis: Just like in the traditional banking world, it gets competitive. Just make sure [the factor is] fully transparent.

What are typical requirements to be approved by a factor?

bert

Goldberg: They’re going to evaluate the applicant somewhat. Mostly they’re going to look at the quality of the invoices. They’re looking at the customer’s ability to pay. They’re going to check that [the business’s] profit margin is sufficient to afford a factor.

What happens if a client fails to pay an invoice?

bert

Goldberg: There are two types of contracts: recourse and non-recourse. With a recourse contract, at a set number of days [60 is common], they will have the client purchase that invoice back. If it’s non-recourse, it depends on why the debtor doesn’t pay. If the product was defective, then the factor isn’t going to be liable for a client’s shoddy work. If the debtor didn’t pay because of financial issues, the factor will take that loss.

Do you view invoice factoring as a long-term or short-term solution? How difficult is it for a business to transition to a more traditional financing option?

denes

Denis: It depends on the business. [Factoring is] designed more to be a short-term option. It’s really those small businesses that need $25,000-50,000, or up to $250,000-500,000. It’s difficult to find that in a traditional banking infrastructure because it costs as much to write a $100,000 loan as a million-dollar loan. A lot of small businesses out there fail, so it’s traditionally seen as a risky market.

bert

Goldberg: The average life of a factoring relationship is 24 months. It’s normal that a client of a factor graduates to a banking relationship. Factors are equipped for that. They help businesses with their cash flow during their growth cycle. Banks won’t finance them until they have sufficient collateral or history, and that’s where factors come in.

Resources

Interested in working with an invoice factoring company? Check out these resources to learn more and find a factor that fits your business:

What Is Factoring & Forfaiting? Business USA offers an overview.

Trends in Supply Chain Finance. David Gustin’s guide to business financing for the U.S. Small Business Administration (SBA).

Your state’s Department of Business may offer suggestions for non-traditional financing, including factoring companies. The “Growing Business in Nevada” page, for example, lists several factors.

Business News Daily explains different types of factoring and offers a brief overview of more than 20 companies to consider.

The International Factoring Association holds members to a strict code of ethics. Goldberg recommends using the factor search feature: “It makes it easy because your information gets emailed out to members that meet the criteria you’re looking for.”

The Small Business Finance Association (SBFA) lists important principles that invoice factoring companies should meet.

SBA’s guide to starting a small business, especially their section on borrowing money, can help business owners make an informed decision between financing options.