How
Invoice
Factoring
Works For
Small Businesses
In this article we are going to discuss how invoice factoring for small businesses. After
reading this article, you should understand what accounts receivable factoring is,
how factoring works, the costs involved, and how to choose the right factor for your
business.
What is Invoice Factoring?
factor, who pays them money for that invoice today.
Example:
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.
Why Invoice Factoring Is A Popular
Financing Option
money (effective interest rate) can be much cheaper than other forms of short-term
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 tends to work best for companies that have invoices that come due
in two to 10 weeks, 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 in this article.
How Invoice Factoring Works
Here is an overview of the 5 general steps that happen when factoring invoices.
Step 1:
Your company and the the factor sign a contract (we show you how to choose the
right factor below). 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.
Step 2:
The factor will send out a “notice of assignment” to the clients you have chosen to
factor. The notice of assignment states that your company has assigned the factor as
the entity to receive future payments for ALL invoices.
Step 3:
You choose which invoices you want to factor. You don’t need to factor all the 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.
Step 4:
The factor provides the agreed upon cash, which is typically 80-85% of the value of
the factored invoice. 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.
Step 5:
The Factor collects the invoice and pays the remaining balance owed to you, minus
their fees. We discuss factoring fees, and how payments work, in detail later in this
article.
Recourse vs. Non Recourse Factoring
Almost all small business factoring is recourse factoring, meaning 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
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
recourse” factoring, but on the contract, they list a huge number of reasons why an
invoice can be exempt from no-recourse. Small business should be very cautious when
being offered non-recourse factoring.
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. Once the factor receives
payment on the invoice, you get the remaining balance, which is also known as the
reserve amount.
Example
Going back to our example, let’s say you factor a $10,000 invoice at an advance
rate of 85%, a discount rate of 3%, and a reserve rate of 10%. In this case you would
receive $8500 upfront. When your client pays the invoice, the factor will pay you the
remaining $1200 you are due, bringing the total amount you receive to $9700. The
remaining $300 is kept by the factor as their fee.
Discount Rates Are Not Fixed
Too bad discount rates are not flat fees per invoice, they vary based on how long it
takes for the factor to receive payment on the invoice after making the advance to
you. For example, it’s not unusual to have a daily, weekly, or monthly discount rate.
A one-percent weekly discount rate would mean that an invoice that took 20 days
to get paid would have have a total discount rate of 3% (number of weeks x weekly
discount rate). However, it took 22 days, 1 day over 3 weeks, it would count as four
weeks instead three.
Typical Micro Factor Rates
For micro factoring, David Rains of Factor Help indicates that a discount rate of 2-5%
for 30 day invoices is within reason. The cost of taking money from a factor would be
approximately the equivalent of a loan with 24 – 60% APR. While this might sound
high, it’s important to keep in mind that the alternatives can be much more expensive.
For example, short-term business loans often carry interest rates that are in the 50 –
60% range. Merchant cash advances, where a firm sells future credit card receivables,
often have effective interest rates of 80% or more.
Other Fees
It should be noted that some factors charge a fee for the service of factoring (a factor
fee) , plus a discount rate. Be sure to ask about this and take any additional factoring
fees into account when comparing factors.
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 (such as construction) factoring.
Small businesses will want to work with self-described mico factors or small business
factors. 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. A good
starting point is to make sure that the factor you choose to work with is a member of
the International Factoring Association (IFA), the professional association of factors.
On the IFA’s website they have a factor search tool which will help you find the factor
right for your business.
Before signing up, have a legal professional carefully look over the factoring contract,
and see if the terms and conditions make sense.
How To Get Approved By The Factor
Factors can be very picky with whom they do business. There are two main reasons:
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.
How Factors Decide Who To Approve
Jeff Callendar of Dash Point Financial is a micro factor. When taking on clients, he
carefully scrutinizes both the client and their clients who will be paying the invoices.
With the company that sells the invoice, his firm wants to see that the business owners
are good citizens. They don’t have a criminal history, large unpaid IRS or state tax bills,
or an army of bill collectors after them. However, he is willing to take on businesses
that don’t have a long-established or developed credit history.
The analysis he does on the firms that will be paying the invoices (the debtor) is
different. The payee should be a well established firm, who has a track record of paying
their bills within a reasonable time of it being due. Most business credit reports track
how long on average after a bill is due does a company pay. This is very important
when evaluating potential debtors.
Factoring Is A Good Option, But It takes A Little Time To
Learn The Ropes
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.