What is invoice factoring? What you need to know before you use it

Even a successful business can find itself with a cash flow shortage, but invoice factoring can help you solve that problem. For the right type of business, the approval process is fast and straightforward, but it’s not the cheapest type of business funding.

Not to be confused with invoice financing — where you borrow against your outstanding invoices but still retain control of them — invoice factoring involves selling your unpaid invoices to a third-party firm that takes over the collection process.

What is invoice factoring?

Invoice factoring — sometimes known as debt factoring — is a type of small business revenue-based funding where a business sells its outstanding invoices to a factoring company at a discount, in exchange for cash, based on the value of those invoices.

The factoring company pays your business a percentage of the invoices’ total value up front — typically 80% to 90%. Once the customer pays, the factoring company sends you the remainder of the invoice total minus its fee.

Most of the time, factoring companies have a recourse agreement. This means if a customer fails to pay its bill, you’ll have to repay the advance. However, you may be able to get a non-recourse deal where the factoring company assumes most of the risk, but this is a more expensive option.

And, most commonly, the factoring company handles the invoices after you sign up, and customers are notified that the invoices have been assigned to the factoring company. Some factoring firms offer the option of confidentially managing your receivables by essentially acting as an extension of your business. This move could be a good idea if you’re concerned that customers might see the sale of their invoices as an indication that your business is struggling — no matter what the reality is.

How does invoice factoring work?

Businesses that invoice most of their customers often have a significant period between when invoices are sent and when they get paid — usually 30 to 90 days. This can sometimes create gaps in cash flow that invoice factoring aims to bridge. It usually works like this:

1. Your business provides goods or services to other businesses or organizations.
2. Your company issues invoices to those clients.
3. You apply to sell your outstanding invoices to a factoring company.
4. The factoring company reviews your application and may offer an advance of 80% to 90% of your invoices’ value up front.
5. Your clients remit their payments to the factoring company.
6. The factoring company sends you the remaining value of your invoices minus the factor fee.

Invoice factoring example

Let’s say your company has a $20K invoice due from a customer. After you invoice the customer, you submit the invoice to the factoring company. The factoring company purchases your invoices for 80% of its face value at a 5% fee.

The factoring company deposits $16,000 into your account, supplying you with immediate cash flow. Once your customer pays its invoice to the factoring company, it sends you the remainder of the invoice amount, less its 5% fee.

In this scenario, you would get back an additional $3,000 ($4,000 of the remaining invoice balance – $1,000 fee = $3,000), for a total of $19,000.

Invoice total	$20,000
Factor fee of 5%	$1,000
Initial advance from factoring firm (80%)	$16,000
Remainder of invoice	$4,000
Remainder of advance minus fee	$3,000
Net from invoice	$19,000

How much does invoice factoring cost?

Factoring companies vary in how they structure fees, but you should expect to pay somewhere between 1% and 5% of the invoices’ value. The exact rate depends on the amount you hope to get, the total of your outstanding invoices, the creditworthiness of your customers and other factors.

You may also be charged other fees, including application fees, services fees, or late fees if a customer doesn’t pay their bill on time. Be sure to ask about any extra fees you might be on the hook for — a low factor rate may not be worth it if other fees are too steep.

Who is invoice factoring best for?

Invoice factoring is usually best for B2B companies that carry a substantial amount of outstanding invoices. It might also be a good option if your credit profile isn’t in great shape, since approval is based more heavily on the value of your invoices — and the reliability of your customers — rather than your credit score.

Pros and cons of invoice factoring

Pros

• Fast funding. When you need quick access to cash to cover operating expenses or purchase inventory, invoice factoring can be quicker than other types of business funding.
• Easier to qualify for. Loans from banks typically have much stricter requirements than factoring companies.
• It’s not a loan. Invoice factoring is more of a transaction than a loan because you’re selling your invoices to the factoring firm. This means no monthly payments to budget for or impact on your credit.
• No collateral required. Many forms of business funding require collateral to secure the loan. But because this is a sale rather than a loan, you don’t have to risk your assets.
• Invoice collection falls on invoice factoring company. Chasing payments from customers can be a hassle, so allowing a third party to handle it can free up staff for other duties.

Cons

• More expensive. Invoice factoring can be a pricier form of funding than other business financing options.
• Cuts into profits. Factoring involves selling your invoices at a discount, meaning you’ll never receive the full value of those invoices.
• No control over invoices. In most cases, the factoring company handles the collection of invoice payments, so your connection with customers may be diminished.
• Risk of non-payment. If a client fails to pay their bill, you may have to repay all or most of the advance you received.
• Not suitable for all businesses. For the most part, factoring companies only work with business-to-business (B2B) firms.

Eligibility requirements for invoice factoring

To be approved for invoice factoring, you’ll need to have some, if not all, of the following:

• A business that invoices its clients
• Reliable, creditworthy customers
• A business bank account
• Accounts receivable aging report

You may also need to submit recent bank statements or other business financials and it’s possible you could be subject to a credit check.

How to get invoice factoring?

If you meet the basic eligibility requirements for invoice factoring, you’re ready to seek approval.

1. Assess your unpaid invoices. Get an idea of the value of your outstanding receivables and come up with an amount you’re hoping for.
2. Compare lenders. Search for lenders that can accommodate what you need. Some may have minimums or maximums that can help you decide which fits your business. Also, be sure to compare factoring rates and any additional fees.
3. Gather your documents. Find out what documentation you’ll need to submit for approval so you’re prepared for the application.
4. Apply. Most likely, the application can be filled out online, or you can talk to a representative if you need help with the application process.
5. Read the contract. Read over the terms and conditions carefully before you sign the contract.

Invoice factoring vs. invoice financing

Sometimes, people confuse invoice factoring with invoice financing, but there are a few key differences. Most notably, invoice financing doesn’t involve selling your invoices. Instead, you take out a loan based on the value of your invoices and repay it as your customers settle their bills.

Invoice financing might be preferable to factoring if you want to maintain closer relationships with your customers and keep control of your accounts receivables. Plus, invoice factoring could cast doubt in the minds of your customers if they think you have cash flow problems — no matter how profitable you actually are.

However, if you have reliable customers, don’t want to take out a loan and would like to ease the burden of collecting payments, invoice factoring could be the right way to go.

Alternatives to invoice financing

Invoice financing is one alternative to invoice factoring, but there are several other funding options.

• Merchant cash advances (MCAs). Another form of short-term funding, merchant cash advances allow you to borrow based on a percentage of your future sales. However, you might need to make weekly or even daily payments, which may be difficult at times.
• Business lines of credit. A business line of credit can help you meet cash flow shortages and other business expenses, but credit score requirements are typically more strict.
• Business credit cards. Credit cards can be easier to qualify for than other funding options, but business credit cards may not help if what you really need is cash.
• Online loans. You might be able to qualify for a fast business loan from online lenders, although you’ll need a good credit score to get the best rates and terms.
• Equipment loans. If you need to purchase tangible assets for your business, equipment financing might be a good option. Plus, the equipment acts as collateral for the loan, so you could qualify for better rates, although you may need a down payment.
• SBA loans. Loans backed by the Small Business Administration could potentially be a more affordable option, but the SBA loan process is often lengthy and can be difficult to qualify for.
• Purchase order financing. If you’re only looking to fulfill a customer’s purchase order from a supplier, this type of financing can cover the costs of goods up front. This type of loan gets repaid once your customer pays for the goods.

Bottom line

Invoice factoring provides a straightforward solution to borrowing money when you need a fast cash flow. It’s an effective financing option, especially if your credit isn’t perfect or you’ve had difficulties obtaining a more traditional business loan.

However, this invoice-based financing option can get expensive and may come with risks that are difficult to predict. Compare other funding options to make sure invoice factoring is right for your business.

Frequently asked questions

What happens if my customer doesn’t pay their bill?

Depending on your agreement with the factoring company, you may have to repay the advance if a business doesn’t pay what it owes, which could put you in a tight spot. It might be possible to shift more of the risk to the factoring company but expect to pay higher rates.

Do I need good credit to get approved for invoice factoring?

Even if a factoring company checks your personal credit score — which they may not — it’s generally more concerned with the creditworthiness of your customers than you.

Do I need to sell all my invoices to get approved?

That depends on the factoring company. Some factoring firms want to take over all or most of your invoices. But you may be able to request selective factoring, where you only use one or some of your invoices. For example, if you have one large invoice you want to be paid immediately, a factoring company may agree to a one-time deal.

Do my customers need to know I’m selling their invoices?

Not necessarily. In most cases, customers are notified that their invoices have been assigned to a factoring company and that’s where they should now direct their payments. However, you may be able to use confidential factoring where clients aren’t notified that they’re paying anyone but you.