Invoice factoring is great for businesses looking to cover payroll, invest in inventory, or pay daily business expenses. With factoring, businesses can sell their pending invoices to a third-party company (factor/lenders) in exchange for 80% to 90% of the invoice value. Typically, the transaction fee would be deducted once all the customers’ invoices have been paid.
Businesses use invoice factoring for a variety of reasons. A lot of business usually has to wait a couple of weeks before they get paid. Without cash on hand, they won’t be able to pay for their day to day business needs which can result in inefficiency. With invoice factoring, however, companies can sell their invoices in exchange for cash up-front. This helps stabilize the business cash flow allowing owners to pay for their day to day operations and other investments.
Invoice factoring comes in two types: recourse and non-recourse. However, people who have little experience in business loans could easily get confused with the different terminologies and concepts. If you’re one of them, you’ve come to the right place.
Recourse Vs. Non-Recourse Factoring: What’s the Difference?
Knowing the difference between these two types is a good starting point in navigating the world of invoice factoring. With that said, here’s how both concepts work:
What is Recourse Financing?
Full recourse factoring is the most common invoice factoring business owners avail. According to the International Factoring Association, 88% of the invoice financing industry practices recourse factoring.
This type of invoice factoring is relatively cheaper because factoring companies only assume a portion of the invoice value. This means that in non-payment, the business takes full responsibility for paying back the borrowed amount. You can choose to save money, but you have to make sure your clients have an excellent credit history.
Remember, if your clients refuse to pay within the agreed period, the lender can charge in invoices back to you. This creates a massive problem for your cash flow, especially if you are still trying to break even. In cases like these, you will be given three options to resolve the issue:
- You can pay the money back;
- Replace the invoice with another invoice of the same value; or
- Pay the borrowed amount using the reserves.
The good thing about factoring is that lenders will make sure not to leave you dry. After all, their primary purpose is to help your business resolve cash flow issues, not add to it.
What is Non-Recourse Financing?
Non-recourse factoring is a type of factoring arrangement where the factoring company assumes the credit risk of the invoices it purchases from the client. In a non-recourse factoring agreement, if the customer who owes payment on an invoice fails to pay, the factoring company assumes the risk and absorbs the loss. This means that the factoring company cannot pursue the client for payment of the invoice or any losses incurred due to non-payment.
Non-recourse factoring companies are responsible for collecting payments, so you can focus more on running your business efficiently than chasing customers for payments. Many business owners choose non-recourse financing solely for the benefit of delegating debt collection tasks.
Compared to recourse factoring, non-recourse financing is more expensive mainly because the factor assumes 100% of the risk. For instance, a factor may charge 3% on invoices under recourse factoring, while non-recourse factoring fees would be 4%.
This type of factoring can be particularly attractive to businesses with customers that have a higher risk of non-payment or industries with a higher level of credit risk. However, it's important to note that not all factoring companies offer non-recourse factoring, and those that do may have stricter eligibility requirements.
Should You Go With Factoring with Recourse or Non-Recourse?
The industry you are associated with may influence your choice between non-recourse vs. recourse factoring. For example, it has generally been understood that most transportation and freight companies may choose the latter.
To be on the safe side, you can look for factoring companies that offer both types of factoring. Regardless of the type you choose, try speaking with only reputable factoring companies. Then, compare the terms each company offers. Some companies also have a credit team to help you avoid working with customers with bad credit.
Whatever type of invoice factoring you choose, the best way to stay safe is to transact with creditworthy customers. Not only will this help you avoid the risks, but you will also get the chance to pay lower fees associated with invoice factoring.