Dozens of unpaid invoices can put a dent in small business cash flow. Since your clients don't usually pay you right away for the goods and services rendered, invoice factoring can provide immediate funding so you can continue to pay for payroll, utilities, and other operational expenses.
Invoice factoring allows you to convert outstanding invoices into working capital. This is a great financing option for businesses that process a significant number of invoices from other businesses.
In this article, we'll discuss invoice factoring for small businesses.
What is Invoice Factoring?
Invoice factoring is a financing option that allows small business owners to sell unpaid invoices to a factor or factoring company in exchange for immediate funding. Banks, independent finance providers, and online lenders provide invoice factoring services.
How It Works
Suppose you own a retail store and sell your products to another business. You've invoiced them for $15,000, and they agree to pay it off within 60 days. However, you find out that you need immediate working capital to pay your employees.
Many small business owners apply for a bank loan, but banks often require collateral, a stellar credit rating, and an established business model. If you do qualify for a bank loan, you'll have to wait for several months to complete the entire transaction.
With invoice factoring, you enter into an agreement with a factoring company. You sell your invoices to them in exchange for upfront funding and receive up to 80% to 90% of the total invoice value. The factoring company will oversee your sales ledger and credit control throughout the agreement.
When your customers need to pay, they will direct their payment to the factoring company. The factor will then forward the rest of the amount to you, minus their fees.
The Pros of Invoice Factoring
The most notable benefits of invoice factoring are that you don't have to wait for 30, 60, or even 90 days to receive payment from services rendered. Here are some of the benefits of invoice factoring:
Invoice factoring is an excellent option if you need cash ASAP and you can't afford to wait for months for additional working capital. The underwriting process for traditional loans often takes a month or two, and then it takes another week or two to receive the money.Invoice factoring gives you immediate access to cash; some factors even offer same-day approval and funding. This allows you to keep your business running smoothly despite payment delays. Immediate funding is especially beneficial if your business is experiencing the following scenarios:
- You have short-term expenses you need to meet.
- You don't want to wait for months to receive payment from your customers.
- You have emergency expenses that you need to address immediately
More Lenient Underwriting Process
Credit rating, loan history, and collateral heavily affect your ability to secure a traditional loan. But for invoice factoring, these aren't major determining factors. Factoring companies are typically more concerned with your customers' creditworthiness because they're the ones paying for the invoices. Factors conduct credit checks to determine the level of risk they're going to take. So, if you have poor credit or short business history, invoice factoring might still be a viable option.
Maintain Positive Cash Flow
Invoice factoring doesn't have to be a one-time transaction. If it makes sense for your business, you can establish a relationship with your factoring company. You can continue doing business with your factor as long as you have invoices to sell. Maintaining positive cash flow wouldn't be an issue because you don't have to wait for payments to hit your bank.
Outsource Payment Collection Tasks
Following up on customers and keeping track of unpaid invoices are tedious tasks. Invoice factoring allows you to delegate these tasks to the factoring company, giving you more time to focus on other tasks that grow your business. The factoring company will be the one to contact your customers for payments.
Strengthen Customer Relationships
Many small business owners know how frustrating and difficult debt collection is. Delegating this responsibility to a factoring company improves customer relationships because you don't have to be the "bad guy" that collects money. This can help you forge positive and long-lasting relationships with your customers.
You don't have to pledge your home, commercial property, equipment, and other expensive forms of collateral to qualify for invoice factoring. The invoices you're looking to sell act as collateral for the loan.
The Cons of Invoice Factoring
While invoice factoring certainly has its benefits, it's not for everyone. Here are some of the disadvantages of invoice factoring:
Invoice factoring can be expensive, although the cost varies depending on the lender you're working with. A factoring company generally charges between 1% to 5% of the total invoice value in service fees. You'll need to assess your finances to decide if the tradeoff for upfront funding is worth it. If your business is operating on a tight budget, you might be better off waiting for customer payments rather than borrowing money at an additional cost.
Highly Dependent on Your Customers
As mentioned, factoring companies look at your customers' credit scores and payment history to gauge the risk they're taking on your invoices. If your customers have a history of late payments, the factoring company will assume that they won't pay you on time either. They will less likely buy your invoices because it's too risky.
With invoice factoring, you're giving the factoring company complete control of your invoices. This doesn't sit well with some business owners because they're not comfortable giving third-party access to their financial information.
It's also important to note that your customers will know that you factored their invoices since they directly pay the factor. This isn't usually a problem for many customers, but it's best to let them know beforehand.
Compare your options and sift through different factoring companies. Check their website, reviews, and contact other people and ask for recommendations. Make sure you're comfortable with a company and its practices before you apply.
Remember that even if factoring companies are in charge of payment collections, they are not collection agencies. They won't go the extra mile to track down and talk to late-paying customers. Depending on your arrangement with your factor, you may need to shoulder unpaid invoices, either through paying for them or trading a different invoice with the same amount.
Comparing Different Factoring Companies
To ensure that you're only working with the best factoring company, ask potential factors to provide you with a list of fees that they require. Crosscheck the factoring contract and make sure all the fees are clearly outlined. If it's your first time applying for invoice factoring, it's best to consult with an accountant or a small business lawyer when reviewing factoring companies and contracts.
There are hundreds of factoring companies you can choose from. Shop around and consider rates, customer support, repayment terms, industry familiarity, length of experience, and reputation of the factor to find out which company best fits your needs.
What's Next? Should You Apply for Invoice Factoring?
Like any other financing solution, invoice factoring doesn't work for everyone. It's best for companies that process invoices, need a quick injection of cash to address short-term expenses, can afford invoice factoring fees, and have creditworthy customers.
If you don't fall under these categories, you can explore other funding options like asset-based loans, SBA loans, inventory financing, or business lines of credit.