Invoice Factoring: What It Is and How It Works

What is invoice factoring?

Invoice factoring is a type of business financing that involves selling your unpaid invoices to a third party at a discount in exchange for an advance of cash. This type of funding allows B2B companies to access fast capital in order to manage cash flow issues or pay for short-term expenses.

How does invoice factoring work?

Invoice factoring isn’t technically a small-business loan. Instead, you’re selling your outstanding invoices to a third party, usually a factoring company, at a discount.

In exchange, the factoring company advances you a percentage of your invoice amount, possibly up to 90%. The company assumes responsibility for collecting full repayment on your invoice and once it receives that payment, it sends you the difference, minus the agreed-upon fees.

How much does invoice factoring cost?

Factoring companies typically charge fees at a flat rate, ranging from 1% to 5% of the invoice value per month. Additional fees may include service fees, monthly minimum fees and origination fees, among others.

The specific factoring fee you receive will range based on the invoice amount, your sales volume, your customer’s creditworthiness and whether your factoring agreement is recourse or non-recourse.

If you have a recourse factoring agreement, you are ultimately held responsible for the debt if your customer fails to repay their invoice. With non-recourse factoring, on the other hand, the factoring company assumes most of the risk associated with nonpayment. If your customer doesn’t pay, the company accepts that loss.

Non-recourse factoring agreements are less common, but will often have higher transaction fees because of the additional risk the factoring company takes on.

» MORE: Current business loan rates

Invoice factoring example

Here’s a more detailed example of how invoice factoring works:

• You invoice your customer. You sell goods to another business, creating a $10,000 invoice.

• You sell your invoice to a factoring company. The factoring company agrees to buy your invoice and advance you 85% of the total value, or $8,500.

• Factoring company assumes responsibility for your invoice. The company collects repayment from your customer.

• The factoring company charges fees. The factoring company charges a 3% factor fee for every 30 days it takes your customer to pay the invoice. Your customer pays in 30 days, so your fee will be 3% of $10,000, or $300.

• The factoring company sends you the remaining balance, minus fees. Now that your customer has paid, the factoring company will send you the remaining 15% of the invoice amount, or $1,500, minus the $300 fee. You’ll receive a total of $1,200 back. This means at the end of the process, you’ve received $9,700 out of the total invoice amount of $10,000 — calculating to an approximate APR of 42.35%.

Pros and cons of invoice factoring

Pros

• Fast cash. Invoice factoring can provide immediate access to working capital to help cover a funding gap caused by slow-paying customers.

• Improved cash flow. Factoring can also allow you to keep loyal customers on longer payment terms while still improving your cash flow to help you grow your business.

• Easier to qualify. Factoring companies often prioritize the value of your invoices and the creditworthiness of your customers when evaluating your application, as opposed to more standard business loan requirements. This makes invoice factoring a good option for businesses that may not qualify for more traditional loan options, such as startups or those with poor credit histories.

• No collateral required. Because you’re selling your invoices to a factoring company, this type of financing doesn’t typically require another type of collateral, such as real estate or inventory.

Cons

• Can be expensive Invoice factoring can be expensive. Although fees may seem affordable at first, they can become costly fast if your customer takes a long time to repay. You also have to watch out for hidden fees, such as application fees, processing fees for each invoice you finance, credit check fees or late fees if your client is past due on a payment. 

• Not for every business. Invoice factoring is best for businesses that work with other businesses because transactions involve invoices. Businesses that sell or work directly with consumers, therefore, won't qualify for this option.

• Loss of direct control. With invoice factoring, your factoring company works directly with your customers. This means you must trust your factoring company to deal with your customers in a responsible and fair manner, and hope they don’t affect your relationships in a negative way.

» MORE: Options for getting a startup business loan with no money

Invoice factoring vs. invoice financing

Invoice factoring may be confused with invoice financing, which is a similar type of business funding.

With invoice financing, however, you use your unpaid invoices as collateral to get a cash advance in the form of a loan or line of credit. You remain responsible for collecting payment on your invoices. Once your customer pays, you repay your lender the amount loaned, plus fees and interest.

Although both of these types of business loans can be good for B2B companies that need fast access to capital, invoice financing may be better-suited for businesses that want to retain control over their invoices.

If you have a strong relationship with your customers and they repay their invoices on time, invoice financing may also be a more affordable alternative to invoice factoring.

» MORE: Our full comparison of invoice factoring vs. invoice financing