Although factoring has been around for thousands of years (for example, medieval businessmen and English colonists all used factoring), online invoice factors have made it more accessible to many small businesses looking for quick and simple access to capital to meet business needs. To determine whether or not factoring is the right approach to meet your business needs, it makes sense to understand what factoring is and how it works.
What is Factoring?
Technically, factoring is not a loan. It is better described as an advance on accounts receivable.
A “factor” is a third party that purchases part or all of a company’s accounts receivables at a discount. The factor then “owns” the outstanding invoices and collects from the customers. The factor profits from the difference between the discounted rate negotiated to buy the receivables, and the full amount collected from the customer.
How Does Factoring Work?
There are many independent factoring companies (including online factoring companies) along with many banks that offer factoring services. Most factors target specific businesses based upon their volume and the amount of their invoices. Some even target specific industries. Factoring is a preferred way of financing within the textile industry, for example. As a result, some factors specialize in that industry. There are also factors that specialize in other industries, so it makes sense to ask when looking for a factor.
Once you choose a factor, they will likely review your client base to determine the creditworthiness of your clients and review your previous invoices and how successful you have been at collecting those invoices. If deemed acceptable, the factor will negotiate with you to purchase your invoices. There is no standard factoring arrangement, so be prepared to negotiate with your factor. You should expect the factor will likely offer to pay you 85 percent to 90 percent of the face amount of your invoices and advance a percentage of that amount, depending upon the creditworthiness of your clients and other factors.
In addition to the discounted purchase price for your invoices, you should expect to pay fees that could range from two percent to 4.5 percent of the total invoice amount for every 30 days the invoice is unpaid after factoring. Payments are generally advanced within one to three days, and the factor will then collect the total value of the invoices from your client. Once the invoice is paid, the factor will pay the balance agreed upon, minus any fees.
The fees in a factoring agreement are based upon variables such as the credit quality of your clients and the size of their invoices. These fees may be negotiable in the initial contract with the factor and can vary from one factor to another.
You should be aware that the invoices you sell to the factor will then be collected by the factor, and the factor likely has a legal right to communicate directly with your clients to ask for payment.
There are Two Types of Factoring: Recourse and Non-Recourse
- Recourse Factoring: This is the most common form of factoring in the United States. In this type of arrangement, the factor buys your accounts receivable with the understanding that you will pay the factor for any invoices they are unable to collect.
- Non-Recourse Factoring: In this type of arrangement, the factor assumes all the risk for uncollected invoices. If an invoice goes unpaid, your business would not be liable. Because of the additional risk to the factor, fees are usually higher than those with a recourse factoring arrangement.
Does Factoring Make Sense for Your Business?
Factoring is a valid option for many businesses, but is not a good fit for others. For example, a baker who sells pastries to three or four of the local hotel chains on invoice might be a good fit for a factor, while another baker who sells pastries to walk-in customers on the corner wouldn’t be a good fit. It’s often used in manufacturing because of the traditionally long cycle for producing consumer goods that are distributed through multiple channels before ultimately reaching consumers. It’s also used in many industries involving business-to-business sales.
Reasons to Consider Factoring
- Factoring can be a good option for small businesses looking for quick access to capital without going into debt, giving up equity, or encumbering capital assets.
- Factors provide immediate working capital so your company can continue to produce and ship without interruption while giving clients payment terms.
The Cons of Factoring
- Factoring can be expensive when compared to the cost of traditional lines of credit
- You must typically be willing to allow the factor to collect the invoices directly from your customers
Depending upon the industry and the nature of your business, factoring may be a viable option to many small businesses in need of capital—and is the preferred method of financing in some industries. The ability factoring provides to access capital quickly makes it a viable option for many small business owners.
Like any other options to secure capital, it’s important to do your homework to make sure this is a good option for you and your business. Because there is no standard factoring arrangement, make sure you completely understand the terms of any factoring agreement before you sign on the dotted line.