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As a business owner, finding financing can be difficult. Trying to get approved for a traditional bank loan is a lengthy process that often results in a rejection letter. Other lenders may provide a quicker answer but with a stringent approval process.
For startups and companies that don’t have extensive credit or those with less than stellar credit, there is a financing option that provides them with immediate cash. It’s called invoice factoring. In this article, you’ll learn what it’s all about.
Invoice factoring allows a business to sell the value of its invoices to a company called the factor. The factor will provide the business with 70%-90% of the invoices’ value within one to three days. The remaining 10%-30% is called a reserve and is held by the factor. Once all of the invoices have been paid, the reserve minus a fee is paid out to the company.
Invoice factoring is not a loan and won’t show up as such on your balance sheet. No collateral is required to use invoice factoring.
There are two methods to factoring invoices. One is to sell all of your invoices to a factor, which is called “whole ledger.” The second method is to be selective about which invoices to sell. This method is called “single invoice discounting” or “spot factoring.”
In summary, invoice factoring is the selling of a company’s accounts receivables to a factor for a cash advance, based on the value of outstanding invoices.
Invoice factoring isn’t just for companies with poor or no credit; it’s also for those needing a cash injection. Cash is the lifeblood of any company but when cash flow decreases to a trickle and working capital dwindles, the company experiences what’s called a cash flow crunch. Without a quick dose of cash to fund its operations, the company will miss supplier payments and ultimately succumb to its inability to meet payments.
By selling its invoices, the company will receive a much-needed cash infusion. Rather than waiting for customers to pay on net 30 or net 60 terms, the company is able to put its cash conversion cycle back on track and pull out of its downward spiral.
Invoice factoring fees vary by factor. Typically, fees range from 1%-5% of the outstanding invoices’ value. Some factors charge a one-time setup fee that ranges from $500-$2,500 plus a brokerage fee of 3%, based on the value on of invoices. Note that the percentage fees are charged each month.
Fees will vary based on who is taking on the most risk—you or the factor. This is known as recourse and non-recourse factoring.
Recourse factoring—with recourse factoring, when a customer doesn’t pay an invoice, you have to buy back that invoice. This puts the risk of nonpayment on you. Fees for recourse factoring are on the lower side of the fee structure.
Non-recourse factoring—the factoring company takes on the risk with non-recourse factoring. The factor will cover invoices that customers fail to pay. For this additional risk, the factor charges more.
As you can imagine, invoice factoring is not a cheap financing option. But when it’s the only option to get your company through a difficult financial situation, it’s a price worth paying.
Like fees, invoice factoring requirements vary by factor. There are a few common requirements across factors. These include:
Once your invoices are sold to the factor, you are no longer in control of them. The factor handles collecting payment from your customers by initially sending them a Notice of Assignment.
This process can be confusing to your customers. All of a sudden, they are being told to mail payments to a company they’ve never heard of. Additionally, if the customer is late with any payments, how will the factor handle it?
There’s certainly reason to be concerned. You’ve spent a lot of time building trust with your customers. That trust can be damaged with the use of a factor…unless you take steps to smooth the transition.
Rather than allowing the factor to suddenly appear as the face of payment collections for your company, notify customers ahead of time. Let them know you are offloading payment collections to another company. Some factors can appear as a department within your company, providing a seamless transition.
Choosing a factoring company comes down to fees, services offered, and customer service. Do you want a fixed fee, tiered or percentage-based?
Services include whole ledger vs. spot factoring. Other services include integrating with your accounting system to better streamline the entire process.
For customer service, do you want a factor that is able to appear as a unit within your company? If not, how does the factor handle late payments? You want the factor to treat your customers fairly, just as you would, and not act like a second-rate collections agency.
While they may sound similar and some use these terms interchangeably, they are two very different types of financing. Invoice financing, also called invoice discounting, uses a company’s accounts receivables as collateral for a loan or line of credit. The company is still liable for collecting customer payments on invoices, which puts the risk of collection on the company and not a factor. The company is advanced an amount similar to what they may receive with invoice factoring.
Fees can be a little less with invoice financing since the factor is not assuming all of the collections risk. Also, the factor does not take over your collections. This means customers still pay you directly and have no idea that your accounts receivables are being financed.
Invoice factoring provides a great way to quickly inject cash into the coffers of a company. For companies that have used up all of their working capital, invoice factoring can be a savior.
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