What is Invoice Factoring? How Does it Help Small Businesses?

Utilized across various industries like construction, trucking, and staffing, factoring is used to temporarily bridge cash shortfalls while awaiting client payments to arrive. It is used when other financial alternatives, like bank loans or merchant cash advances, don’t make financial sense.

Contents:
• What is Invoice Factoring?
• Advantages of Factoring
• Disadvantages of Factoring
• How to Assess a Factoring Company
• Is Invoice Factoring Right for You?

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So, What Exactly is Factoring?

Invoice factoring (or accounts receivable factoring) is a financial option where you sell your yet-to-be-paid invoices getting you working capital quicker than waiting on client payment. The factoring company will “advance” a percentage of the invoice amount, typically between 70% to 95%, then return the remaining percent after your client pays them (less their fee).

Let’s illustrate with an example. Imagine you are a small but growing concrete contractor that has recently landed a business-changing project. After tackling the job you send the invoice to your client for payment. But because you are small and have limited resources, their 60-90 day wait for payment really hurts. It’s going to be difficult making payroll, much less pre-purchase materials for upcoming projects.

Being in the construction industry really limits your ability to get a line-of-credit from the bank. And other forms of financing like MCAs have downright scary repayment terms. This is why invoice factoring can be the perfect fit.

What to Expect — Factoring a $75,000 invoice:

	terms:*	$75,000
Advance Payment Timeframe	1-2 days after factoring agreement approval
Advance Payment Amount	80% of the invoice amount	$60,000
Factoring Fee	4% flat rate	$3,000
Additional Fees	$500 application fee	$500
Returned Remainder	after client payment (30 to 90 days)	$11,500

* These rates and fees are typical, however each factoring company will have its own factoring fees and/or rates, and possibly additional fees.

Advantages of Invoice Factoring

Of course, factoring is not a perfect solution for every business. But in the right situation, there are many advantages for a company to use factoring:

• Fast Funding
  Compared to the time it takes to get a bank loan (assuming you can even be approved for it), money from factoring can be available in as little as one business day after the account is created.
• Flexible Use
  Funds can be used to:
  • pay reoccurring overhead such as rent, utilities, lease payments, payroll
  • pay subcontractors
  • purchase materials and supplies
  • hire employees or staff-up for upcoming projects
  • improve internal infrastructure and efficiency with new billing software, tools/equipment, etc.
  • invest in marketing and advertising
• Easier Qualification
  Qualifying for many business financing solutions like lines of credit from banks, especially if you are in construction, can be a difficult and lengthy process. There will be mountains of paperwork and stringent credit checks. While there will be some paperwork associated with factoring, there will much less than is required by banks.
• No Collateral Needed
  Loans and lines of credit often require substantial collateral. Factoring, however, only uses your invoices as collateral. This means you can keep your materials, equipment, and other assets separate.
• Maintains Extended Payment Terms
  Another benefit of invoice factoring is that it allows companies with cash flow issues to continue to bid on jobs with 30 to 90-day payment terms. The factoring company ensures you are paid quickly – they wait for the client’s payments. This enables you to compete effectively without avoiding projects with extended payment terms.
• Uniquely Suited to Small/New Companies
  The factoring decision-makers approve the funding based primarily on your client’s credit history, not yours. This means that if there’s minimal or less-than-perfect credit, factoring can be a powerful solution for smaller companies looking to pay bills and grow their business.

Disadvantages of Factoring

• Fees
  Yes, factoring fees tend to be more than those of banks (but are less than Merchant Cash Advances). Of course, the specific fee amounts vary among factoring companies.
• Contractor/Client Relationship
  The factoring company will communicate directly with your client.
• Liability Does Not Fully Transfer
  In the unlikely event that your client defaults, the factoring company may come back to you for payment.

How to Assess a Factoring Company

There are many aspects that need to be considered when picking the best factoring company for your unique situation. Here are a few of the common considerations when assessing a factoring company.

1. The Invoice Factoring Fees, Rates, and Other Costs

Factoring fees vary depending on many options. 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.

2. 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. Trusted factoring companies will often receive positive reviews and testimonials on Google or at the Better Business Bureau. Of course, you can always ask others in your industry who they’ve used.

3. Industry Specialization

One advantage of working with factoring companies that specialize in your industry is they will be familiar with the unique aspects 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.

Another benefit is that specialized factoring companies might offer industry-specific support services and education. They can assist with lien management, offer Notice of Assignment (NOA) services, and provide guidance on navigating construction regulations.

Additionally, factoring companies that specialize in industries like construction, often have an established network and connections within the industry. 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.

4. Funding Limits

Most factoring companies will prominently advertise and verbally communicate their funding limits as part of their onboarding process. Keep in mind that the final funding limit is determined on a case-by-case basis and is subject to the factoring company’s assessment and the risk associated with the invoices it will be factoring.

5. Customer Service and Support

Everyone deserves top-notch customer service. Companies with substandard service won’t last long in today’s competitive marketplace. Look for ones that have an established track record and refined their service over years of working within your industry.

6. Recourse vs. Non-Recourse

This aspect of factoring refers to who is ultimately liable if the payment is not received. With recourse factoring, the business selling the invoices retains the ultimate responsibility for payment. With non-recourse factoring, the factoring company assumes all the credit risk for non-payment by the debtor.

Is Invoice Factoring Right for You?

Factoring should be considered a viable option for a small business if:

there is a lag time between you completing a job and getting paid.

your business is new or does not have established credit (but your client does).

you don’t have time to wait on the bank’s slow paperwork processing and decision-making.

you need money but don’t want an option that affects (or potentially hurts) your credit rating.

With any choice, picking a factoring company included, some will be a perfect fit, others won’t. By understanding their pros and cons, and carefully selecting the right factoring company, you can use the best one for your business. And if you have questions about how factoring might fit within your unique business needs, feel free to reach out.

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