Invoice Factoring

Small business owners know that cash flow management is essential to keeping their doors open. There is often a frustrating mismatch between when your rent comes due and when customers pay their invoices. Waiting for payment, especially if you offer longer 60 or 90-day payment terms to customers, can cause you to fall behind on your operating expenses.

Paying your rent late costs you a late fee, missing payroll could lose you key employees, or you might have to pass up opportunities to accept new customers or expand. The solution for many small business owners may be invoice factoring.

Invoice Factoring is a form of financing that lets small and medium businesses take cash advances on their accounts receivables. Instead of waiting weeks to receive payments on invoices, these businesses get paid quicker. It allows you to use the funds you have already earned to run and grow your business.

If you need access to capital quickly, you can get your invoices financed online and it just takes a minute to get started.

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    What is Invoice Factoring?

    With invoice factoring, a business sells its accounts receivables, i.e., its invoices, to an external financing company. These companies, known as factor or factoring companies, buy invoices at a discount and then typically advance 70-90 percent of the invoice’s total value to the borrower. The remaining balance is forwarded to the business when the customer pays their invoice, minus a fee.

    Also referred to as accounts receivable factoring, or ‘invoice financing,’ a small business owner either pledges the invoices as collateral or sells them outright. If the business owner pledges them as collateral, they are using them to secure a short-term loan and retain responsibility for collecting the balances owed.

    How do factoring companies work?

    First, you have to decide which factoring company to work with, taking into account their reputation, the factor rate they charge, and how quickly they can fund your loan. The factor will likely want to see your past due invoices and may verify amounts owed and the creditworthiness of your customers. If the factor agrees to work with you, you can then sell or pledge your outstanding invoices for working capital.

    To hedge their risk, the factor pays the business owner 70 to 90 percent of the invoice’s total. For an invoice of $5,000, you could receive $3,500. Once your customer eventually pays the invoice in full, the factoring company sends you the remainder of the invoice less a fee.

    There are usually three parties involved in a factoring transaction; your business or the invoice issuer, your business’ customer or the business that owes payment on the invoice, and the factoring company that supplies the cash.

    Factoring process step-by-step:

    1. After delivering the product or service to your customer, you issue an invoice with net terms.
    2. Once you have issued an invoice, you can sell it to the factoring company, even if it is not past due.
    3. The factoring company advances money, typically between 70-90% of the value of the invoice.
    4. Now that you do not have to wait for the customer to pay, you can pay employees, pay your bills, or buy materials and inventory.
    5. After the customer pays the outstanding invoice, you receive a “rebate” for the balance of the funds, minus the factor’s fee. The fee is based on the term and value of the invoice.
    6. It is a win-win for all three parties involved: the small business owner gets cash up front, their customer receives favorable payment terms, and the factoring company collects a fee.

    Pros and Cons of Factoring

    B2B companies with outstanding receivables will find many benefits to factoring. But certain types of businesses or industries will discover there are also disadvantages.

    Pros | Advantages

    • Quick access to working capital to run your business
    • Offer flexible and longer payment terms to clients without worrying it will impact your daily operations
    • Borrow based on your clients’ creditworthiness, not just your business income and FICO, likely receiving higher credit limits

    Cons | Disadvantages

    • B2C companies are ineligible for invoice factoring, as are companies without notable, larger clients
    • Pay more to access capital than with traditional bank financing
    • Potentially liable for overdue invoices

    Choosing the best factoring company for your business

    Working capital is essential for small businesses to maintain operations and overcome cash flow gaps. Rent payments and payroll come due even if a major customer has not paid their bill. Equally as important to accessing capital is choosing the right financing provider partner.

    If you sell your invoices directly, the factoring company will be collecting on them. You do not want someone who is unprofessional representing your business to customers. Even if you choose to pledge them instead, the terms, factor rates, and funding speed matter directly to you.

    To help you better choose the type of factoring company that is right for you, here are eight questions to ask while exploring your options.

    What types of factoring services do they offer?

    When choosing an invoice factoring company, consider the type of service your business needs. Do you want to factor all of your outstanding invoices, or do you want to choose which invoices to submit for funding? Are you willing to take on the risk a customer fails to make payment on an invoice?

    Here are key factoring terms and options that you need to be aware of when choosing a factoring company:

    Spot factoring vs. Whole Ledger Factoring

    • Spot Factoring: Spot Factoring allows you to factor a single invoice on a one-time basis. There is no long-term contract, which allows for more flexibility. However, with spot factoring, fees tend to be higher.
    • Whole Ledger Factoring: A business must submit all their client invoices with Whole Ledger Factoring, also known as Full Turn Factoring. Rates are generally lower than you pay with spot factoring, but most whole ledger factors will charge a hefty termination fee if you cancel your contract.

    Recourse vs. Non-recourse

    • Recourse: With recourse factoring, business owners shoulder the risk if their customer does not pay the invoice on time. If your customer does not pay the invoice that you submitted to the factoring company, you have to cover the costs and buy back the invoice from them. Because recourse factoring is less risky for the factor, it is generally a more affordable option than non-recourse factoring.
    • Non-Recourse: With non-recourse factoring, business owners are not liable if their customers fail to pay the outstanding invoice. However, because the factoring company takes on more risk, the fees tend to be higher. Additionally, most non-recourse factors will not accept invoices from customers with low credit scores and poor payment history.

    Factoring vs. Invoice Financing

    • Invoice factoring: Invoice Factoring is the name for selling a business’s accounts receivables at a discount to a factoring company in exchange for a cash advance. The advance amount is typically 70 to 90 percent of the sold invoice, and the factor company assumes responsibility for collecting on the invoice. Unlike traditional bank financing, factoring gives you more flexibility because the cash you receive depends on the invoices you submit and is technically a debt-free source of financing.
    • Invoice financing: With Invoice Financing, business owners do not sell their accounts receivables to the factoring company. Instead, the business owners pledge their accounts receivables as collateral for a loan. The loan amount depends on the strength of your invoices, both the amounts due and your customer’s creditworthiness. A small business has more risk with invoice financing because the invoices are still under your ownership.

    What terms and rates do they offer?

    Factoring companies charge either a variable or flat fee. As a general rule, if you factor more invoices, you will pay a lower rate.

    With variable fee structures, also called tiered fee structures, factors discount a small percentage of the invoice for as long as it is outstanding. The longer your invoice goes unpaid, the more fees you’ll accrue over time. While more complicated to calculate, variable fee structures can be more cost-effective depending on your business’ profile because the rate is based on the risk of the account.

    With a flat fee structure, the rate does not change, no matter how overdue the invoice is. However, flat-rate fees are generally higher than the variable fees. To calculate a flat fee rate, multiply the face value of an invoice by the flat fee.

    If you have many clients that consistently pay well before their net terms, it is more cost-effective to use a flat rate fee structure than a variable fee structure. It is also easier to predict the total fees you will pay in this instance. Businesses in the transportation industry more commonly use flat fee structures for simpler accounting.

    A number of factors determine factoring terms and rates, including, but not limited to:

    • The business’ industry
    • Volume of invoices
    • Net terms of invoices
    • Type of service provided
    • Quality of clients (time in business, credit score, etc.)

    What industries do factors work with?

    B2B businesses with well-known clients and longer net terms – which lead to cash flow gaps – make great candidates for accounts receivable factoring. These industries are heavy users of factoring:

    • Transportation
    • Distribution
    • Construction
    • Oil and gas service companies
    • Manufacturing
    • Staffing services
    • Consulting
    • Marketing, PR & creative companies
    • IT services and software development
    • Commercial services
    • Retail

    Are there hidden costs or fees?

    Some invoice financing companies charge fees or penalties that are hidden in the fine print. Always read your loan documents thoroughly and know what triggers the penalties in order to avoid them.

    • Termination Fees: If you sign a long-term contract with a factor and decide to cancel it before it expires, you may pay a sizable cancellation fee. Termination fees can range from 3% to 10% of your credit line.
    • Monthly Minimum Fees: Some factors require businesses to factor a certain amount of invoices per month. If a business does not factor enough invoices to meet its minimum, the factoring company charges an additional fee.
    • Maintenance Fees: This fee, usually charged monthly, keeps your account open/current with the factoring company.
    • Due Diligence Fees: Due diligence fees apply whenever the factor must verify your client’s background. The factor makes sure that your client doesn’t have any existing liens, such as unpaid taxes, is in good credit standing, and more. Due diligence fees can range from a few hundred to a couple of thousand dollars.

    What’s in the factoring agreement?

    When you sign an invoice factoring agreement, you enter into a financial contract. The agreement explains the costs and terms of your factoring plan in complex terms and provisions, and since it is legally-binding, you need to study and understand it before signing.

    Check the rates and make sure that you understand the terminology used – such as minimum annual commission or customer limit. If you do not understand something, ask your factoring company. You want to avoid the high (and sometimes outrageous) cancellation fees that some factoring companies charge. And if a long-term contract requires you to factor a certain number of invoices, you should be comfortable that you can meet that minimum.

    What’s the factor’s advance rate?

    An “advance” rate is the percent of the invoice face value that the factoring company advances to you upfront. A fair advance rate is 70-90% of the face value of the invoice. For example, if your customer owes you $2,000, a cash advance payment of $1,400 to $1,800 would be industry-standard.

    How quickly can you get funds?

    Some factoring companies, especially traditional factors, can take months to set up your business account. Alternative lenders like Shield Funding can get your account set up in less than 10 days. Once your account is set up, they can get you funds in hours.

    Online financing companies use through automation to make due diligence more efficient. Modern factors verify your customers, your invoices, and any existing liens on your business faster and more efficiently than in the past. After the initial set-up, most modern factors can have the funds deposited in your bank account within hours after you submit an invoice.

    Do they offer good service?

    Depending on the complexity of your business, and if you are new to invoice factoring, you will want to speak to a financing advisor. They can answer questions before, during, and after your application.

    Whether you choose to work with an online or traditional factor, dealing with a real person on the other side will make the process go smoother. They can help you navigate unexpected challenges and make sure you’re getting the appropriate amount of funds for your business.

    Are you a good fit for invoice factoring?

    After you have considered each of these questions, you will probably have a good idea if invoice factoring fits your business and industry. Then you can look for an invoice factoring company that will give you the best combination of features, flexibility, and terms.

    Talk to other business owners in your industry to find out who they work with and get recommendations. Search out and read online reviews, and ask thorough questions of any potential invoice factoring lender.

    With a little research, you will find a partner and agreement that offers you everything you need; funds, flexibility, transparency, and terms that support your business. Look for a partner you’ll want to work with long-term, as having an established relationship with a factoring company makes borrowing easier.

    Shield Funding offers a streamlined approach to invoice factoring

    An alternative lender with over ten years of experience, Shield Funding specializes in online invoice financing for business owners who want the best from their factor. We give you flexibility, speed, and transparent rates and terms. We offer companies spot factoring up to $5 million. With our easily navigated dashboard, you will receive funds in as fast as one business day.

    If you are interested in learning more about invoice financing or any type of business loan, financing specialists can help. Call 1 (888) 882-6117 to find out more today.