Article summary: Factoring is not a loan, but is one of the oldest sources of capital for businesses around the world. Here’s what you need to know about factoring, how it works, and whether or not it’s the right choice for your business.
What is Factoring?
Factoring is not a loan, but rather the sale of a company’s accounts receivable at a discount to a third party, known as a factor. The factor then owns the outstanding invoices and collects from the customers. The factor earns a profit from the difference between the discounted rate negotiated to buy the receivables and the full invoice amount collected from the customer.
How Does Modern-Day Factoring Work?
In addition to more traditional factors, today there are online factors that use technology to make the process easier and more streamlined. Nevertheless, the following will apply whether the factor works online or offline.
- Contract with a factor: If your business and your invoices qualify with the factor, you and the factor will sign a financing agreement. This agreement will establish the maximum amount you can be advanced and will specify which invoices you want to factor.
- Your customers will be notified: The factor will usually send what’s called a “notice of assignment” to those customers whose invoices you are factoring. The notice is to let them know your company has chosen to have the factor collect their outstanding invoice(s).
- You will receive an advance: Depending upon the factor, the industry you’re in, the invoices, and other risk factors, you will receive an advance between 70-90 percent of the value of the factored invoice(s). Again, there are exceptions, so you should make sure you understand the specific terms before you sign an agreement with any factor.
- Your invoices are collected: Once the factor collects payment for the agreed-upon invoices, they will pay the remaining balance owed to you, minus their fees. Every factor is a little different, and as mentioned above, the discount rate varies depending upon a number of factors, so make sure you understand the specific terms.
Many factors prefer to specialize in specific industries where they are familiar with the common industry practices. With that in mind, you may want to look for a factor that specializes in your industry.
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There are Two Types of Factoring: Recourse and Non-Recourse
Before you agree to factor any of your invoices, you need to be aware that there are two types of factoring:
- Recourse Factoring: This type of factoring agreement requires that you will pay the factor for any invoice he or she is unable to collect within a reasonable amount of time. This is the most common form of factoring in the United States.
- Non-Recourse Factoring: The factor assumes all the risk for uncollected invoices in this type of factoring arrangement. As a result, the fees associated with non-recourse factoring are usually higher.
A Short-Term Business Loan as an Alternative to Factoring
Factoring could be a good way to access capital to overcome short-term cash flow needs, and it’s also standard practice in many industries. It’s not a viable option for businesses that don’t bill on invoice or are in an industry a factor might not be interested in.
If you have a healthy business and don’t want to engage with a factor, OnDeck offers small business financing with a simple application, a quick answer, and fund availability often within 24 to 48 hours of approval.
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Financing options to help you grow your business
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