How Invoice Factoring Works For Small Businesses

What is Invoice Factoring?Invoice factoring is when a firm sells an invoice which is due to them in the future to a factor, who pays them money for that invoice today.

ExampleLet’ say you’re a temporary staffing service which has provided $20,000 of staffing services to ACME Manufacturing. !The payment term for this $20,000 invoice is net 30 days, meaning ACME Manufacturing has 30 days from the date the invoice is issued, to pay the full invoice amount.

It is your slow season, and you are short on the cash needed to pay your employees. You can’t wait 30 or more days to receive the money from ACME Manufacturing. !One solution would be to work with a factoring company, who will purchase the invoice and advance you the money you need now (minus their reserve and fees), in return for the payment you are due on the ACME Manufacturing invoice.

Example

Why Invoice Factoring Is A Popular Financing Option

The cost of money (effective interest rate) can be much cheaper than other forms of short-term financing.

Invoice factoring is great way to finance short-term cash flow shortfalls.

A company can factor specific invoices which match their working capital needs in terms of both dollars and timing. For example, if you need money to cover three weeks of expenses, you can pick an invoice to factor which gives you the cash to cover your next three weeks worth of expenses.

Invoice factoring is also much more flexible than other types of financing.

And have clients that consistently pay on time or a little late. A common mistake is to factor invoices due in in 60 to 90 days from late payers. This creates problems which we discuss later.

Invoice factoring tends to work best for companies that have invoices that come due in two to 10 weeks

How Invoice Factoring WorksHere is an overview of the 5 general steps that happen when factoring invoices.

Step 1:

When you sign up with a factor, you decide which clients you want to factor. More clients can be added later. The factor will conduct due diligence on the clients you want to factor, to see if they are good credit risks. Based on that due diligence, the factor will set an initial maximum dollar amount of your total outstanding invoices that you can factor.

Your company and the the factor sign a contract.

Step 2:

The notice of assignment states that your company has assigned the factor as the entity to receive future payments for ALL invoices.

The factor will send out a “notice of assignment” to the clients you have chosen to factor.

Step 3:

You don’t need to factor all the invoices for a client, even if they have been “assigned”. You tell the factor which specific invoices you want to factor. When the factor receives payment for an invoice that hasn’t been factored, they immediately pass the payment on to you.

You choose which invoices you want to factor.

Step 4:

This is what is known as the Advance Rate. Before providing cash to the company, the factor may follow up with the company’s client to verify the invoice.

The factor provides the agreed upon cash, which is typically 80-85% of the value of the factored invoice.

Step 5:

Minus their fees. We discuss factoring fees, and how payments work, in detail later in this presentation.

The Factor collects the invoice and pays the remaining balance owed to you.

Fundbox provides a simpler alternative to traditional invoice factoring.

Sounds complicated?

Recourse vs. Non Recourse Factoring

Almost all small business factoring is recourse factoringMeaning if the invoice doesn’t get paid in 90 days, then the factor has the right to sell-back the invoice to the company. This can be a big problem if you have already spent the money you received from the factor, and don’t have additional revenue coming in to buy the invoice back.

This is why you should only factor invoices that you know will get paid in 2 to 8 weeks. Jeff Callender of Dash Point Financial says it’s a mistake to factor invoices from clients that are high risk, or chronically very late payers. When the factor sells back the invoice, the company will have to come up with the money to repay the factor “with interest”, often creating a new cash flow problem.

Non-recourse factoring is when the factor cannot sell back the invoice to the company.

If the invoice doesn’t get paid its the factor’s problem. True non-recourse factoring is very rare, however, a number of firms advertise offering it. They advertise “non-recourse” factoring, but on the contract, they list a huge number of reasons why an invoice can be exempt from no-recourse.

How Much Invoice Factoring Costs,

And How Payments

Work

Factors charge what is called the discount rate.The discount rate is the difference between the amount of the invoice, and the total amount the factor company pays to you.

A discount rate of 3% would mean that the invoice is being bought for 97% of its face value. This means if you factor a $10,000 invoice, at a discount rate of 3%, you will receive $9700 in total from the factor, assuming the invoice is paid.

Keep in mind That you do not receive full payment upfront when factoring. The total amount paid to you by the factor comes in 2 parts. You get the advance rate amount upfront, which is typically 80-85% of the invoice amount.

Find an Example of Discount Rates, Typical Micro Factor Rates and Other Fees at:

How To Choose A Factor

There are 725 factoring companies in the United States. There is a tremendous variety in the services they offer, how they conduct their business, and what they charge. For example, some factors will not work with companies that average less than $250,000 per month in invoices. Others only do industry specific factoring.

A micro factor is a company that specializes in factoring amounts less than $25,000 per month. You also want to make sure you are not dealing with a “shady” operation. !On the IFA’s website they have a factor search tool which will help you find the factor right for your business.

Micro factors or small business factors.

How To Get Approved By The Factor

1. They have limited capital, and can only support the factoring needs of a limited number of companies. By taking your company on as a client, they may have to pass on other business.

!2. While it is not easy to defraud a factor, the factor needs to be able

trust that if a factored invoice gets paid to the company (and not the factor) by mistake, the payment will immediately be forwarded on.

Factors can be very picky with whom they do business. There are two main reasons:

Check how factors decide who to approve by checking our main

article here:

But It takes A Little Time To Learn The RopesFactoring Is A Good Option,

Factoring is a little more complicated than getting a loan from a bank, because the collateral for the “loan” (the invoices) is always changing. However, what makes factoring complicated is also what makes it appealing.

A company can get cash at an effectively low interest rate,

Because it’s a “loan” secured by collateral. Furthermore, the “loan” can be for a very short-period (because, it’s tied to the collateral). Invoice factoring is a great tool for getting short-term cash based on future payments.

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