As a small business owner, you can turn any of your unpaid customer invoices, (i.e., accounts receivables) into cash quickly with invoice factoring. If you have customers that don’t pay for goods or services upfront but need cash in hand to run your business, this option is best for you. Invoice factoring can also be used for payroll, hiring new employees, investing in marketing, buy equipment and materials for projects. It is popular for small businesses in the recruiting, manufacturing, construction, printing, and wholesale industries.
What is Invoice Factoring?
Invoice factoring is not a business loan but provides an advancement on payments for outstanding invoices. You sell your invoices at a discount to a third-party factoring company in exchange for cash. The invoice factoring company collects the full amount of the invoice from the client on your behalf. Most small businesses can qualify because the factoring companies consider the credit of the client instead of your own.
Invoice factoring is available to B2B (business to business) and B2G (business to government) companies who have invoices from $10,000 up to $10 million due in 30-90 days. The factoring fee, or discount rate, runs from 1% to 5% depending on the amount of the invoice, sales volume, and your customers’ credit.
If your client doesn’t pay, some companies offer recourse factoring, where your business becomes responsible in case the client defaults. There’s also nonrecourse factoring, where the factoring company absorbs the costs. Nonrecourse factoring may sound less risky for your business, but it is expensive.
Pros and Cons of Invoice Factoring
- Fast cash: you can receive immediate working capital to help cover any funding gaps your business may have due to slow-paying clients. You will have the money for your invoices before they have been paid.
- Improved cash flow: you can bring in more money and take on new projects while improving your cash flow to help grow your business.
- No credit requirements: there is no minimum credit score or at times will even accept poor credit.
- Great for new businesses: invoice factoring is available to new and small businesses. If the factoring company does require a certain time in business, it will be only less than a year.
- No collateral necessary: no collateral is required with invoice factoring since it is unsecured financing. It also doesn’t require a personal guarantee.
- Approval is easy: invoice factoring provides financing to companies that may not be able to get anywhere else, such as a bank due to poor credit or limited business history. Factoring companies are only concerned about the creditworthiness of your clients and the invoice value.
- Liability: you may be held responsible for any unpaid invoices. If your client doesn’t pay, you are liable and will need to pay. The factoring company expects to be paid back like any other lender would.
- High cost: although there are not many sets of specific requirements, invoice factoring can be expensive. From hidden fees such as application, processing, and late fees, it can be very costly for you.
- It is not a loan: if you need the funds to expand your business or take on large projects, invoice factoring is not for you. It is an advance, not a loan.
- You lose control with clients: the factoring company handles payment requests after selling your invoices.
Common Mistakes Small Businesses Make
Small businesses make the following mistakes when considering invoice factoring. Be sure to avoid the following:
- Not reading the fine print. Be sure to read the contract carefully for the factoring fee and any other hidden fees that come with your advance.
- Not knowing the difference between purchase orders and invoices. They are not the same so if you need an advance for purchase orders consider purchase order financing instead.
- Not making time for the required paperwork. Be sure to ask the factoring company about documents they need so you can be prepared ahead of time with the necessary paperwork.
- Relying on invoice factoring only. There are better options for financing if your business relies on less invoices.
- Not knowing the difference between invoice factoring and invoice financing. Invoice financing is more like a loan where you pay interest and fees and is more flexible in terms the value of your invoices.
Invoice factoring is useful for your small business if you have cash flow problems due to unpaid invoices. If you struggle to get traditional business loans or your industry prohibits you from qualifying for them, invoice factoring is the best option for you. Factoring is an attractive choice because it frees up your time to focus on other ways to grow your business while the factoring company takes over.