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If your business provides services to other businesses, then you’re likely familiar with the process of issuing invoices and waiting to be paid. While it’s common for invoices to have 30-, 60- or even 90-day payment terms, this can create issues for your business’s cash flow.
That’s where invoice factoring companies come into play. These companies buy unpaid invoices at a discount so your business gets the funds it needs sooner. Learn more about factoring companies and how to choose the best one for your needs.
What is a factoring company?
A factoring company is a company that provides invoice factoring services, which involves buying a business’s unpaid invoices at a discount. The business is advanced a percentage of the invoice, say 85%, within a few days, and the factoring company takes ownership of the invoice and the payment process. Once your client pays their invoice (directly to the factoring company), you’ll receive the rest of the money your business is owed minus the factoring company’s fees.
Why do businesses sell their invoices to factoring companies? Essentially, to help bridge the gap between when they complete a service and when payment for that service is due. While the business will lose a bit of money to the factoring company, it may be worth it to overcome a cash shortfall. Factoring companies tend to move much quicker than more traditional lenders such as banks, so if you need cash quickly, they can provide efficient solutions.
How factoring companies work
What does it look like to work with a factoring company? If you sell $20,000 worth of invoices to a factoring company, it may agree to buy them for $19,600, taking a 2% factoring fee of $400. The factoring company usually doesn’t give you the full amount upfront. Rather, it may give you 85% upfront — in this case, $16,660 — and then once the invoices are paid, you’ll receive the remaining balance, $2,940.
To make money, factoring companies charge factoring fees (sometimes called discount rates). These fees tend to fall anywhere between 1% and 5% of the total invoice. The factoring fee you end up with depends on how much the invoice is worth, your business’s sales volume, how creditworthy the customer is and whether or not the factor is "recourse" or "nonrecourse." It’s important to note that if the factor is recourse, you may have to pay back the factoring company if your customer doesn’t end up paying their invoice.
Benefits and drawbacks of factoring companies
There are both benefits and downsides associated with factoring companies. The main benefits involve speeding up cash flow. If you need working capital to cover a cash gap when waiting for customers to pay their invoices, an invoice factoring company can step in to help. If longer payment terms are keeping some of your best customers happy, you can keep your payment terms while also keeping your business running smoothly.
On the flip side, working with an invoice factoring company can be expensive due to its fees. You also lose a bit of control when it comes to your customer relationships, as invoice factoring companies take ownership of your invoices and how they get paid.
How to choose a factoring company
If invoice factoring sounds like the right financing solution for your business, then the next step is to find the best factoring company for your needs. As with any type of small-business funding, compare options to make sure you’re getting the best terms and lowest fees possible.
When comparing invoice factoring companies, consider the following:
Types of companies they work with
It helps to work with a factoring company that’s familiar with your industry and business model. If it already works with similar businesses, this experience can help ensure a smooth factoring process. Some questions to ask include:
What size companies does it typically work with?
What industries does it specialize in?
Do businesses need to meet certain criteria, such as time in business or a specific amount of accounts receivable, to work with it?
What their factoring process looks like
You’ll also want to gain a better understanding of what working with each factoring company looks like and what type of service you can expect. Find answers to these questions:
Is there a maximum (or minimum) number of invoices the company will fund?
Will it manage all of your accounts receivable, or will you retain control and decide which invoices to sell?
How quickly will you receive the funds?
What happens if a client fails to pay their invoice?
It’s important to understand the difference between invoice factoring and invoice financing, as you may come across both types of companies when looking for cash flow solutions. With invoice financing, a business uses unpaid invoices as a form of collateral when pursuing a cash advance. In this case, the business is still responsible for collecting payment, whereas with invoice factoring, you pass that responsibility onto the factoring company.
Fees and other requirements
One of the most important details to consider is how much each factoring company charges for its services. It will also likely have requirements that your business must meet in order to qualify for financing. Find the answers to:
How much is the factoring fee or discount rate?
What percentage of each invoice will you receive as an initial advance?
Does the company require a personal guarantee?
What type of documentation (such as tax returns or financial statements) does the company require?