Invoice factoring for small businesses is a great option for businesses who need immediate cash flow and are willing to give up a percentage of the money they are making off of clients.
In this post, we’ll explore the details of invoice factoring, along with the benefits and risks it poses.
How exactly does invoice factoring work? For starters, you must have outstanding invoices for that have already been completed. At this point in time, you may then sell these invoices to a third-party agency. This agency will pay you roughly 85 to 95 percent of the invoice up front and hold on to the rest. They will then assess the “factoring” fee, meaning based on how long the client takes to pay the invoice, for every day or week, they’ll take a percentage, usually up to 6%, of the money they’re holding onto.
Here is an example:
You own a small business that build screened in porches among other things. You have just completed a screened in porch for a client for $15,000. The client now has 60 days to pay for the service. You, however, have some bills you need to pay so you decide to sell the invoice to a third-party factoring agency. They pay you 90% of the invoice up front, in this case $13,500 and hold onto the remaining $1,500 in value of the invoice. The agreement is that they will assess a 4% weekly factoring fee for the payment time of the client. The client pays the invoice after 5 weeks. As a result, the factoring company deducts $300 from the $1,500 and send you $1,200. The factoring company makes a profit and you end up with $14,700 of the original invoice.
Pretty basic overall, and definitely a great option for small businesses in need of an immediate boost in their cash flow for some reason.
There are a few different types of invoice factoring that are available for small businesses. These include recourse and non-recourse factoring and spot factoring and contract factoring.
The difference between recourse and non-recourse factoring revolves around who is responsible or an invoice if it is not paid for by the client.
In a recourse invoice factoring, you are responsible should your client fail to pay the invoice for any reason. This means you will have to buy the invoice back from the company. However, many invoice factoring companies are willing to work with small businesses, meaning they may allow you to pay back the invoice in payments or pay for the invoice by simply replacing it with another one of equal value. Whatever the method, it is important for small businesses to be careful as invoice factoring is usually used to boost cash flow and nothing destroys cash flow like having to buy back an invoice.
In non-recourse factoring, the factoring company is responsible for invoices that aren’t paid, with the exception of disputed invoices. It used a be a very cut-and-dry situation, however, now, non-recourse does not mean that you are freed of being responsible completely. The agreements are now far messier, so it is important that you read the details very carefully if you do sell an invoice to under a non-recourse agreement.
Spot factoring and contract factoring provide different options for businesses depending on how they want to take advantage of invoice factoring.
Spot factoring is where you get to pick and choose invoices to sell to the factoring company. Contract factoring is where you agree to a long-term contract with a factoring agency, and then sell all of your invoices, or most of your invoices, to them during that term.
The benefit to contract factoring is that the fees are typically lower on account of the volume, however, you lose the luxury of being able to pick and choose contracts. Spot factoring, on the other hand is useful for when you only want to sell certain invoices on account of a short-term problem, such as an issue with cash flow.
The great thing about invoice factoring is that it does not depend on your revenue or credit rating. Neither of these matters, since the companies are not interested in your ability to pay but rather your client’s ability to pay the invoice. As a result, invoice factoring is available to most businesses and is one of the few options available for those with poor credit or who just opened their business.
Obviously, invoice factoring isn’t for all businesses and there are many other financing options out there. Invoice factoring is great for companies that suffer from slow paying customers who are holding back their growth, businesses that need immediate access to cash flow, and businesses that suffer from a poor credit rating.
If you are considering invoice factoring as a potential option, a few questions to ask yourself are, can you afford to give up the percentage which will be taken from your invoice? Do you really need immediate cash flow, or is it not worth it? Is the growth and financial stability being impeded by slow paying customers?
If the answer to these questions is yes, then invoice factoring might be highly beneficial for your business. If not, remember there are many different financing options available, so it’s important to research and consider them all, even if you think invoice factoring could benefit your business.
As always, if you have any questions, don’t hesitate to reach out and be sure to check back for future posts on how you can improve, and ultimately grow, your business.