When a business is having difficulty maintaining day-to-day cash flow due to their client’s long payment duration or past due payments, they may need to come up with an alternative, stop-gap solution. Invoice factoring is often used as a quick, low-stress option for many industries. Let’s explore all you need to know about factoring construction invoices to determine if it is right for your business.
Contents:
– What is Invoice Factoring and How Does It Work?
– Advantages of Invoice Factoring
– Common Types of Factoring
– Invoice Factoring vs. Other Funding Options
– Misconceptions About Invoice Factoring
– Is Invoice Factoring Legal?
– Choosing a Factoring Company
– Invoice Factoring Requirements and Eligibility
– How to Apply for Invoice Factoring
– Tips for Successful Invoice Factoring
– Invoice Factoring Examples
– The Decision
Introduction to Invoice Factoring
Invoice factoring is a form of funding that is used in many industries like construction, trucking, or staffing. It is a financial option for temporally bridging day-to-day cash flow shortfalls during the 60-90 days of waiting for client payments to arrive. It is used when other options don’t make financial sense.
What is Invoice Factoring? How Does Invoice Factoring Work?
It is a relatively simple definition: a business sells its yet-to-be-paid invoices to a factoring company. The factor will then pay them a percentage of that invoice amount (advance). After the invoice is paid by their client, the factoring company will send the remaining percent to the company, less their factoring fee.
A typical factoring example using $50,000:
| The Invoice Amount | $50,000 | |
| Advance Payment Amount (as soon as 24 hours) | 80%* | $40,000 |
| Invoice Factoring Fee | 4%* | $2,000 |
| Remainder Returned (after client payment – 30 to 90 days) | $8,000 |
* This example uses a typical factoring fee percentage, however, each factoring company will have its own factoring fees/rates and possibly additional fees.
Advantages of Invoice Factoring
In the right situation, there are many advantages for a company to use factoring:
Fast Access to Working Capital
Speed is often the #1 reason companies partner with factoring companies. Compared to the time it takes to get a bank loan (assuming you can even be approved for it), receiving money by factoring can take as little as one business day after an account is created. Quick access to working capital allows you, the contractor, to immediately fund current projects, maintain your workforce, manage overhead, and continue to scale. With gaps in cash flow, it is much more difficult to operate the company, much less grow. Invoice factoring allows you to continue to build without being handcuffed by your clients’ slow payments.
RELATED ARTICLE: How to Speed Up the Construction Factoring Application Process
Keep Your Extended Payment Terms
Another benefit of invoice factoring is it allows companies who are experiencing cash flow issues to continue to bid on jobs with 30 to 90-day payment terms, just like they would during times when they are not experiencing cash flow issues. The factoring company will ensure that you are paid quickly for those invoices since they will be the ones who wait to receive payments from the client. This allows you to compete with other businesses and not ignore projects with extended payment terms.
Ease of Qualifying
It can be a difficult and lengthy process to qualify for many business financing solutions like lines of credit from banks, especially if you are in construction. But factoring has a relatively simple qualifying process. Most companies are able to easily contract with a factoring company if their invoices reflect they have already worked with creditable clients.
Part of the complexity of trying to get a bank loan will be providing the mountains of paperwork. While there will be paperwork needs associated with invoice factoring, when you apply you probably WON’T need to supply this exhaustive list often required by banks.
Typical Bank Loan Paperwork:
- A loan application
- The project’s details
- Contractor’s qualifications
- Financial statements
- The invoice contracts
- Insurance documentation
- Personal and business documents
In addition to all this paperwork, there is the added time that the bank takes to assess everything and make their decision.
While obtaining bank loans is generally more difficult, there are things that can also make factoring difficult. A factoring company will not like it if you have certain types of liens, large numbers of other financial obligations, or legal issues with your business. If you are free of those, you should be able to receive factoring without issue.
The Invoices Are The Collateral
Loans and lines of credit often require substantial collateral. Invoice factoring, however, only uses your invoices as collateral. This means you can keep your materials, equipment, and other assets separate.
And because underwriting for factoring looks at your client’s credit, not yours, there is no effect on your credit score.
Small or New Companies Can Use Factoring
A traditional bank loan can be hard to get if you are not a large, well-established entity. However, factoring supports these smaller companies in maintaining cash flow, even if they have slow-paying clients. The decision-makers approve factoring based on your client’s credit history, not yours… factoring gets you money based on their history. This means that if you don’t yet have established credit or even have less-than-perfect credit, invoice factoring can be a powerful solution for smaller companies looking to pay bills and grow their business.
Disadvantages of Factoring
Of course, factoring is not a perfect solution for every situation. When talking about the disadvantages of this financing option, higher fees are mentioned most often. They are usually higher than those of banks (but less than Merchant Cash Advances) and there might be other costs. Of course, these fees as not standard across all factoring companies so it is always best to get clarity in advance.
IN-DEPTH ARTICLE: The Benefits of Factoring
Common Types of Factoring
Spot Factoring
Spot factoring is a subset of common invoice factoring. Rather than purchasing a certain number (or all) of your invoices, spot factoring allows the contractor to pick one or a few specific invoices that will be purchased by the factoring company. While spot factoring does offer unique benefits over traditional factoring, it can be slightly more difficult to obtain.
Government Contract Factoring
As the name implies, this offshoot of factoring involves the selling of a government-issued invoice. Working with our government can have its unique challenges such as navigating the Assignment of Claims Act which requires special knowledge that not all factoring companies have. The overall process of applying for government contract factoring is very similar to other forms of factoring.
Whole Turnover Factoring
Whole turnover factoring is a type of factoring arrangement where a contractor sells all their invoices over an extended time period, unlike traditional factoring which works more like a stop-gap solution. It encompasses the company’s entire accounts receivable portfolio of business. Whole turnover factoring provides consistent and continuous financing but can be difficult to obtain and costly.
Recourse Factoring & Non-Recourse Factoring
Recourse factoring refers to a type of factoring where the business selling the invoices retains the ultimate responsibility for payment collection. If the debtor goes bankrupt for example and fails to pay the factored invoice, the business must buy it back from the factoring company. On the other hand, non-recourse factoring is a form of invoice factoring where the factor assumes all the credit risk for non-payment by the debtor. If the debtor fails to pay, the loss is absorbed by the factoring company, relieving the business of any obligation to repurchase the invoice.
Invoice Factoring vs. Other Funding Options – Quick Overview
Factoring vs. Bank Loans
Factoring differs from bank loans in that it provides immediate access to funds based on the value of outstanding invoices, whereas bank loans require collateral and a lengthy application process. Factoring focuses on the creditworthiness of the business’s customers, whereas bank loans primarily consider the creditworthiness of the business itself. The trade-off is that factoring is typically more expensive than bank loans.
RELATED ARTICLE: What to Expect When Getting A Bank Loan in Construction
Invoice Factoring vs. Invoice Financing
Unlike invoice factoring where the business sells unpaid invoices upfront to a third party, invoice financing is where the business borrows money from a lender using its unpaid invoices as collateral. In this case, the lender will make its money by charging interest on the loan, which will vary depending on the lender and the creditworthiness of the business. And because invoice financing is a specialized loan, if there are any problems, penalties will be added.
The business may choose invoice financing over factoring if it wants to retain ownership of its invoices and can afford to wait for the payments to come in. A con of invoice financing is the business is still in charge of collecting the invoices and making payments, unlike factoring where the factor is in charge of collecting their payment.
Factoring vs. Lines of Credit
Lines of credit offer businesses a pre-approved credit limit that can be drawn upon as needed. Like bank loans, “LOCs” will have a much longer, more difficult application process, but offer more flexibility for businesses to access funds when and if required. And they typically have lower rates than factoring.
Invoice Factoring vs. Merchant Cash Advances (MCA)
Invoice factoring differs from merchant cash advances in that factoring is based on the sale of an actual invoice, whereas merchant cash advances provide a lump sum payment based on a percentage of your past credit card sales. An MCA will look at these numbers and decide what you should be able to pay. Their interest rates can vary widely between companies. They are repaid by pulling a percentage of weekly or even daily sales directly from the company’s bank account. For the struggling company, this can be difficult for those with already limited or erratic cash flow.
Common Misconceptions About Invoice Factoring
To the person who has not used factoring before, it is easy to believe stories that may or may not be based on real situations. These misconceptions are ones typically heard when discussing factoring.
Factoring is Only Used When in Financial Trouble
Some believe that factoring may give the impression that your company is experiencing financial troubles. However, invoice factoring can be a strategic financial tool used by many profitable businesses, including construction companies, to proactively manage their cash flow. It can demonstrate a commitment to meeting financial obligations promptly. Factoring can actually enhance a company’s reputation as a reliable and financially stable business.
Factoring Creates Complications with Existing Financing
Some companies may believe that invoice factoring can create complications with their existing financing arrangements. However, factoring is a separate financing solution that does not typically interfere with existing business loans or lines of credit. Factoring companies primarily evaluate the creditworthiness of the company’s customers rather than the company itself. This means that they can still maintain their current financing relationships while benefiting from the additional working capital provided by factoring.
Factoring Hurts the Customer Relationships
It is not unheard of to believe that factoring puts a strain on a company’s customer relationships again implying financial troubles. However, factoring is a common and widely accepted practice in business. The factoring company typically operates discreetly, and customers are usually fine working with a third-party factor in the transaction.
RELATED READING: Top 6 and 1/2 Myths About Factoring Companies
Is Invoice Factoring Legal?
Yes, invoice factoring is legal, fully recognized under the law, and widely used in various industries, including the construction sector. As long as all parties involved agree to the terms and conditions of the factoring arrangement, it is a legal and viable method for supplementing cash flow and addressing short-term financial needs. However, it is essential to thoroughly understand the terms of the factoring agreement, know the fees involved, and work with reputable factoring companies to ensure that everything is fair and beneficial to both you and the factoring company.
What to Consider When Choosing a Factoring Company
1. The Factoring Company’s Reputation
With so many choices in the factoring world, it can be difficult to choose a good one. How do you know they are reputable? They are often members of trade associations and educational groups like the Construction Financial Management Association or the International Factoring Association. Trusted factoring companies will often receive positive reviews and testimonials on Google or at the Better Business Bureau. Of course, you can always ask other people in your industry. They are usually happy to share their experiences – both good and bad.
2. Industry Specialization of the Factor
When researching factoring companies there will be many to pick from. Some support multiple industries, while others choose to focus on unique businesses such as trucking or construction. When considering whether to work with a specialized factoring company, it’s important to weigh the specific needs and goals of your business. You should choose a factoring partner that aligns with those requirements offering the expertise necessary to support your success in the industry.
One advantage of working with factoring companies that specialize is they will be familiar with the unique world of that industry’s clients and their debtors. They understand the typical payment practices of that industry and can accurately assess the creditworthiness of those debtors. This knowledge helps them make informed decisions about which invoices to finance, reducing the risk of non-payment.
Additionally, factoring companies that specialize in, for example, the construction industry, often have an established network and connections within the industry. This synergy could open doors to potential customers, recommend subcontractors, and other industry professionals. They may also have relationships with other service providers such as insurance brokers and construction attorneys. They will even work with other factoring companies, meaning that if the factoring company is not a good fit, the factor will be able to refer to another that is.
3. The Factor’s Funding Limits
As a general guideline, the funding limit range in construction, for example, factoring typically falls between $100,000 and several million dollars. Larger companies with established track records and strong financials may be able to secure higher funding limits. It’s important to note that the funding limit is determined on a case-by-case basis and is subject to the factoring company’s assessment and the risk associated with its invoices.
4. The Invoice Factoring Fees, Rates, and Other Costs
Like funding’s dollar amounts, invoice factoring fees vary depending on many options — the size of the company, the creditworthiness of its customers, the number of invoices being factored, whether they are repeat customers, and the specific terms of the factoring agreement. While individual rates may vary across industries, a typical invoice factoring fee range for the construction industry is around 2% to 5% of the total invoice value.
It’s important to note that the invoice factoring fee may also include additional costs such as administrative fees, service fees, or late fees, which can vary among factoring companies. When working with reputable factoring companies, there will never be “hidden fees”. The specific fee structure will be discussed in the initial phone call and outlined in your factoring agreement. It’s essential to review and understand all fees involved before entering into the agreement.
5. Their Customer Service and Support
One of the significant advantages of utilizing an industry-specific factoring company is the level of customer service and communication they provide. Unlike larger companies or banks where it can be challenging to connect with a real person over the phone, working with a smaller factoring company increases the likelihood of prompt assistance from someone familiar with your business and situation. This eliminates the frustration of navigating through automated phone systems and dealing with representatives who are unfamiliar with your industry. By choosing a smaller company, you can enjoy the convenience of connecting with a person you have worked with before… who knows you by name.
Another benefit is that specialized factoring companies might offer industry-specific support services. They can assist with lien management, support notice of intent (NOI) services, and provide guidance on navigating construction regulations.
The Invoice Factoring Companys’ Requirements and Eligibility
Because of the unique nature of factoring, the requirements can be unique compared to other funding choices. Most requirements are designed to protect not only themselves but also the company they are helping. Every factoring company has its own list so ask questions before committing.
Your General Operations Paperwork
As a general protection, factoring companies usually ask for basic business documents. It goes without saying that working with a business that cannot supply a business license and provide a copy of proof of insurance is dangerous.
Indicators of Your Business’s “Health”
A Factor may want to see documents that help them get an idea of the company’s historic business practices, such as taking work and not completing it. The Factor does not want the client to refuse to pay the invoice because the terms of the job were never completed. Examples of requested paperwork might be P&Ls or balance sheets. Keep in mind that the factoring company is not looking for spotless financials, but they do want to get a general overview of the past difficulty the business has endured and how it was dealt with.
Your Current Contractual Obligations
Knowing how the company has worked, both in the present and in the future, is a big determinant for making the decision whether to or not extend factoring money. It indicates both a company’s ability to complete work and not have upcoming financial issues due to lack of work.
One financial area a Factor looks for is other current loans or financial obligations. It is not unusual to work with companies that take out loans to pay other ones. But it is a problem when it is obvious that the company is overextended to the point that it will never be able to pay everyone back.
It might sound strange but a Factor might also ask about your company’s ownership. They want to be sure the key players involved know about the factoring agreement. It is not unheard of to have one owner trying to hide financials from another owner. Having the signature of both helps ensure communication by all.
Your Company’s Minimum Invoice Amounts
As with all businesses, there are costs involved in running a factoring company. And because they usually work off percentages, factoring a low-dollar-amount invoice may not return sufficient income to offset the labor costs required to service the account. As a result, Factors have minimum requirements on the invoices they will consider.
Smaller factoring companies may be more willing to work with lower invoice amounts, $5,000 to $10,000, while larger and more established factoring companies may need to handle larger invoices, including those in the $50,000 to $100,000 range or even higher.
How to Apply for Invoice Factoring
While there is not one standard application process that every company uses, applying for factoring does not usually have many steps. And with simplicity and fewer steps, there is usually quicker funding.
1. Phone Meeting – Understanding Your Business
Requesting factoring here at CapitalPlus typically starts with an introductory phone call. We will ask a few simple questions about your business. We like to know the states where your projects are located, your billing cycle, and if you have other loans (and the types they are). This helps us determine if invoice factoring will help you and if there are different factoring options that are a better solution for your needs. We do NOT want to recommend a product that is not a perfect fit… we are looking to build a long-term relationship.
2. Offical Agreement and Factoring Underwriting Paperwork
When every question is answered and everyone believes that invoice factoring is a perfect fit, we will send you an application to become a client and a term sheet outlining all the details discussed in the phone meeting like your factoring fees and terms.
After we receive your application we will request a few documents as part of our underwriting process. An example of documents we need is your business license, proof that you have insurance, a copy of the invoice(s) being factored, and a few others.
3. Application Approval
Our factoring underwriting department will take over from here. If all documents meet their standards, you will be notified that you are now an “official” client.
We will then send your client a factoring Notice of Assignment (NOA) letting them know about your new relationship with CapitalPlus and that we will be in contact with them. We will also request a copy of the invoice(s) from the client showing the invoice amounts to verify that all numbers match.
4. Payment Funding
At this point all the above information has been checked and approved – you will receive the initial payment. Depending on whether you are bonded or not, the amount is 70% to 80% of the invoice’s face value.
5. Collection and Payment
After your client pays the invoice and contacts us letting us know the job is complete to their standards, we will send you the remaining 20 to 30% less our factoring fee (you will know this exact factoring fee percentage after the initial discovery phone call.)
Keep in mind that this process may not exactly match the process of all factoring companies.
Tips for Successful Invoice Factoring
Communicate with Your Clients Early
Because a Factor will be working directly with your client, it’s best to make them aware of the new relationship. Most of the time they have no problem with the arrangement, but being surprised can unnerve them. So clear communication is key.
Consider Using Factoring Strategically
While it is most typical to use factoring reactively when cash flow gets tight, do not ignore the idea that factoring can be used proactively. It might make more financial sense to use factoring and take projects with high profit than turn away work simply because invoice factoring has fees. Knowing every cost upfront, including factoring as a funding option allows you to weigh choices that make your company the most money.
Reevaluate Previous Factoring Rates and Agreements
Factoring companies will do all they can to find solutions to best fit your situation… at that time. But you should not discount factoring as a funding option because you assume past terms are fixed. Factors like CapitalPlus have different percentage rates based on invoice dollar amounts, repeat history with you as a client, and many other circumstances. Factoring rates change… get a new quote before assuming you should not consider factoring.
Real-world Invoice Factoring Examples
Here are a few examples of how small business owners in various construction areas have used factoring to help their unique situations. Because these are actual clients, the names have been changed, but the amazing results are real.
General Contractor — James S.
Based in Florida, James’ company was working on a luxury resort hotel project. However, due to the slow payment terms of this client, he knew that his current cash flow would not allow him to make payroll. After receiving funding of $280,000 through factoring, his company was able to pay his subcontractors. He also took advantage of CapitalPlus’ assistance with lien compliance.
Mechanical Electrical and Plumbing Contractor — Joseph L.
Joseph’s company won a bid but their agreement did not allow materials to be invoiced at the time of delivery. Without a cash infusion, he would have to pass on the opportunity. After receiving the $2,000,000 in receivables financing, he was able to purchase materials as well as additional supplies and equipment he needed to start and complete the project.
Concrete Contractor — Michael W.
After landing a $1,200,000 contract with the City of Houston Michael needed a large cash infusion for the upfront costs of the job. He chose factoring and was able to purchase the project’s materials and make payroll during the duration.
RELATED READING: See more of CapitalPlus’ case studies
So, Is Invoice Factoring Right for Your Business?
With any financial solution, factoring companies included, some will be a perfect fit, others won’t. It is our hope that after reading this article you will have a better understanding of invoice factoring, and what to look for in factoring companies so you can choose the best one for your business. As always, if you have questions, feel free to contact us.
Article Sources:
- Nerdwallet. “Business Loan Requirements: 7 Things You’ll Need to Qualify, https://www.nerdwallet.com/article/small-business/how-to-qualify-for-small-business-loans”
- Construction Financial Management Association. “https://cfma.org/”
- International Factoring Association. “https://www.factoring.org”
- Thomson Reuters. “Notice of Assignment, https://content.next.westlaw.com/practical-law/document/I8d74c2f5ef2a11e28578f7ccc38dcbee/Notice-of-Assignment
- Acquisition.gov. “Subpart 32.8 – Assignment of Claims, https://www.acquisition.gov/far/subpart-32.8″
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