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At some point in a business owner’s journey, it’s likely they will need to secure additional financing to help it operate or grow. Even if you’ve previously qualified for a traditional business loan or worked with a generous investor to fund your initial startup, there’s no guarantee that those options will be available the next time you need money—especially in a time crunch. That’s when invoice factoring can come in handy.
What Is Invoice Factoring?
Invoice factoring is a small business loan alternative that lets businesses sell their invoices to a third-party factoring company, which then collects the payments from customers. It’s typically best for companies that generate invoices to other businesses and are in need of quick funding with flexible qualification requirements.
How Does Invoice Factoring Work?
When a company sells its invoices to a factoring company, it typically receives 70% to 95% of the total invoice value—known as the advance rate. Then, the factoring company will collect payment from the customers. Once the unpaid invoices are collected, the factoring company pays the business the remaining balance minus the factoring fees. Factor fees, whether fixed or variable, typically range from 0.50% to 5% per month an invoice remains outstanding.
Invoice Factoring Example
Let’s say you sell an invoice that has a value of $25,000, receive an advance rate of 80% and pay a 5% factor fee. Here’s an example of how much you’d pay and receive in total.
Recourse vs. Non-recourse Factoring
There are two types of invoice factoring:
- Recourse factoring. If a customer doesn’t pay their invoice, businesses in a recourse factoring agreement are required to buy back that invoice from the factoring company at the end of the term.
- Non-recourse factoring. Third-party factoring companies take on more risk through non-recourse factoring because they cannot require you to buy an invoice if a customer does not repay it.
Because recourse factoring poses less risk to the factoring company, it’s typically the more common agreement. Further, non-recourse factoring fees are generally higher because it’s riskier for factoring companies.
How to Choose an Invoice Factoring Company
There are many ways to compare an invoice factoring company. Invoice factoring companies can charge different fees, have different minimum invoice amounts and work with different industries. Start by finding invoice factoring companies that work with your specific industry. Then, compare their fee schedules and qualification requirements to find a company that matches your specific business situation.
Pros and Cons of Invoice Factoring
Pros of Invoice Factoring
- Easy way to improve your cash flow. Invoice factoring may be a faster and simpler way to improve your cash flow without taking out a business loan or line of credit.
- May be easier to qualify for. If you have a damaged personal credit score, invoice factoring may be a better option—or your only option—than other types of business lending that have more stringent qualification requirements.
- Suitable for new businesses. If your business is new or doesn’t qualify for a traditional business loan, invoice factoring may be one of the few financing options available to you.
Cons of Invoice Factoring
- Potentially long contracts. Invoice factoring is not a one-off lending program. Some factoring companies may require you to sign a contract for up to one year.
- May spend time chasing down invoices. If you’re eligible only for recourse factoring, you’ll be responsible for any unpaid invoices. This can add more time and hassle than you want to deal with.
Invoice Factoring vs. Invoice Financing
Invoice factoring and financing have one key difference that makes them two different types of business financing. When you choose invoice financing, instead of selling your invoices to a factoring company, your invoices serve as collateral—something of value that a lender can repossess in the case of a default—and secures a cash advance. Businesses that use invoice financing are responsible for collecting payment and use those funds to repay the lender.
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Frequently Asked Questions
Is factoring invoices a good idea?
Whether or not invoice factoring is appropriate depends on your business, cash flow and other factors.
If you can qualify for a low-interest business loan, you may end up paying less than if you choose invoice factoring. But if your business is relatively new or has little-to-no cash flow, you may not qualify for a traditional business loan, or you’ll receive high interest rates if you do. In that case, invoice factoring may be an idea to consider.
How much does factoring invoices cost?
Invoice factoring companies charge different fees but most fall between 0.5% and 5%. If you’re interested in invoice factoring, you can contact a factoring company to get a personalized quote. The exact fee you pay may depend on the invoice volume, your business’ industry and your customers’ creditworthiness, among other factors.
Is invoice factoring a loan?
Invoice factoring is not a traditional business loan where you receive a lump sum of money and pay it back over time. Instead, you’ll receive a portion of an invoice amount upfront from a factoring company. Once the factoring company collects the invoices, you’ll receive the remaining balance minus any fees.