What Is Invoice Factoring? The Complete Guide

Have you ever wished that you could leverage the value of incoming invoices to support growth initiatives? You can with invoice factoring, and doing so can help you avoid cash flow interruptions that impact your business.

While roughly 60% of business owners experience cash flow issues at some point, invoice factoring can help businesses mitigate these interruptions. When used to fuel your growth, invoice factoring can help you get the resources you need to make strategic investments and maintain your organization’s cash flow.

Let’s take a look at what invoice factoring is, how it works, and how to choose the best factoring company for your needs.

Table of Contents

• How Does Invoice Factoring Work?
• Types of Small Business Invoice Factoring
• Invoice Factoring Example
• The Pros and Cons of Invoice Factoring
• How Much Does Invoice Factoring Cost?
• When to Consider Business Invoice Factoring
• How to Choose the Best Invoice Factoring Company
• Alternatives to Invoice Factoring
• Invoice Factoring Is Just One Option

How Does Invoice Factoring Work?

Invoice factoring is a form of accounts receivable financing that lets you sell your existing invoices to a third-party factor at a discount. It’s a way to access capital tied up in unpaid invoices without having to wait for customers to pay what they owe. Typically, factors give 80 to 90% of the invoice’s value less any applicable fees. 

Invoice factoring typically follows this process:

• Step 1: The business contacts a factoring company to sell their invoices for immediate capital.
• Step 2: The business sets up an account with the factoring company and drafts an agreement that covers the contract’s scope, amount, and fees.
• Step 3: The factoring company conducts due diligence on the invoices to be factored, the invoices’ validity, and the customers’ capacity to pay.
• Step 4: The factoring company provides the business with a copy of the final factoring agreement stating that they’ll buy your specified invoices and give you a specified percentage of their value minus the factoring fee paid to the factoring company.
• Step 5: The factoring company gives the business capital after both parties sign the agreement.
• Step 6: The factoring company becomes responsible for collecting the invoice payments through a notice of assignment (NOA). 
• Step 7: The business’s customers pay the factoring company what they owe, settling the business’s debt.

The process lets you access capital tied up in invoices so you can cover your expenses and grow your business without waiting for invoices to be paid. 

Keep in mind that some factoring companies may notify your customers that they’re now legally collecting the invoice payments. If you’re concerned about your customers knowing that you’re selling their invoices, you may want to consider working with a different factoring company. 

Some offer non-notification factoring, which keeps the transaction discreet. If keeping this information confidential is important, ask potential lenders about their notification policies before signing an agreement.

Types of Small Business Invoice Factoring

Companies can choose from several main types of business invoice factoring to gain access to capital. While the type you’ll want to pursue depends on your business’s needs, you’ll want to fully understand your options before you start looking for a factor company to partner with.

Here are the most common types of factoring:

• Spot factoring: This allows businesses to selectively factor single invoices, making it ideal for covering occasional slow periods.
• Selective invoice factoring: This method lets businesses choose several invoices at once. 
• Recourse factoring: This method allows businesses to factor invoices if they take on the responsibility of collecting payments from their customers and repaying the factoring company. If they fail to collect payments, the business must repay the factoring company for the cost of the unpaid factor.
• Non-recourse factoring: This method makes the factoring company responsible for collecting factored invoice payments. If the customer fails to pay, the factoring company bears the loss.
• Contract factoring: This method lets businesses enter into agreements with factoring companies that allow them to factor a minimum number of invoices each month. 

The factoring method you choose will largely depend on your company’s needs and your concerns over your cash flow.

Invoice Factoring Example

Let’s look at how invoice factoring can work in practice. Say Company A sold ten pieces of equipment for a total of $1 million. The terms state that these are payable 30 days after the delivery of the units. 

We’ll assume that Company A was sent a larger-than-expected order. They needed to buy inventory to meet the demand quickly, but cash flow was tight after their initial purchase. They’re looking for ways to generate immediate cash flow to sustain business operations.

To free up working capital, Company A decides to factor the invoice:

1. Company A contacts a factoring company to sell invoices worth $1 million for immediate capital. 
2. Company A sets up an account with the factoring company and drafts an agreement that outlines the scope and amount of the contract as well as any fees associated with it.
3. The factoring company does its due diligence into Company A’s invoices and provides Company A with a copy of the final agreement to buy their invoices for a total of $980,000 less a fee of $200,000, and agrees to pay Company A 90% of the total invoice amount. This comes to $702,000.
4. Both parties sign the agreement and the factoring company gives Company A $624,000 up front in a lump sum payment.
5. The factoring company then collects payments for the outstanding invoices.

Every situation is different, but this example should give you an idea of what to expect if you factor your invoices.

The Pros and Cons of Invoice Factoring

As with any business activity, invoice factoring comes with its own fair share of pros and cons. Let’s explore some of the advantages and potential downsides of this type of financing.

Review any possible factoring agreement before signing on the dotted line, and consider how the benefits and downsides may impact your business.

How Much Does Invoice Factoring Cost?

Contrary to many invoice factoring myths, this financing method doesn’t have to be terribly expensive. While different factoring companies can set different terms, most charge monthly fees based on a percentage of the invoices’ values.

The fees often range from 1% to 5% of the invoice value per 30 days. For example, if you factor an invoice of $10,000 with a 2% time-based factoring fee, you might pay $200 per month until the customer pays the invoice in full. If your customers pay their invoices quickly, the fees you pay can be very low.

Be sure to compare the fees each factoring company charges before you agree to the terms. This way, you’ll know how much you’ll be responsible for before you enter into a contract.

When to Consider Business Invoice Factoring

Invoice factoring can help your business quickly improve its cash flow and can be a great alternative to traditional loans and lines of credit. However, it’s not the perfect solution for every business need. Let’s take a look at a few situations that invoice factoring can help you solve:

• You want to accelerate the expansion of your business but cash flow is tight: Invoice factoring can provide capital upfront, making it easy to take advantage of growth opportunities, even when cash flow is tight. 
• You received a large order request: If a customer places a large order and you don’t have the cash upfront to purchase new inventory to accommodate their request, invoice factoring can help. You can leverage outstanding invoices to get the money you need to accommodate their order.
• You want to negotiate better rates with vendors and suppliers: Vendors and suppliers may be willing to give you better rates if you pay your invoices quickly. By using invoice factoring, you’ll gain access to upfront capital that you can use to quickly repay vendors and potentially negotiate better rates on future orders.

Factoring is a flexible way to give your business the injection of capital it needs to thrive. However, taking on a commercial loan may be a better option, especially if you need access to larger amounts of capital.

How to Choose the Best Invoice Factoring Company

As much as factoring companies can consider whether or not to buy your invoices, you have the right to choose which factoring company to work with. Every company works in slightly different ways, but there are a few things you’ll want to consider when looking for a factoring partner:

• The company’s knowledge of your business model: Choose a factoring company that is an industry expert with experience working with businesses like yours. This way, they’ll have better knowledge of how financing terms flow within your business model.
• The company’s fees: Be mindful of the fees that each factoring company you’re considering charges for their services. If possible, compare the factoring companies that offer the lowest fees.
• The company’s responsiveness: The best factoring company should be able to respond to your concerns quickly and help you gain the funds you need as fast as possible. Pay attention to the company’s responsiveness as you start your search and prioritize the ones who respond fast.
• The company’s flexibility on terms: Some factoring companies ask you to enter into a contract and set a minimum number of invoices they’re willing to factor. Consider each company’s terms and choose the company with terms that meet your needs. 

Try to be mindful of how each factoring company’s services will integrate into your business. If one company feels too restrictive, too slow to respond, or has no experience working with businesses like yours, choose a different company.

Alternatives to Invoice Factoring

Invoice factoring isn’t the only option you have when it comes to gaining access to capital. Here are a few alternatives you may want to consider:

• Commercial loans: Commercial loans are a form of financing that provides access to capital through an external lender. You can use them for most business expenses.
• Small business loans: SBA loans are a financing option backed by the Small Business Administration and are designed to help smaller businesses with potentially less established credit and business histories qualify for financing.
• Business lines of credit: These lines of credit allow you to borrow and use money from a lender for business purposes. They function similarly to credit cards and allow you to borrow money up to your credit limit and repay what you borrow multiple times. You’ll only pay interest on the amount of money you use.

Speak with your lender to see which options best fit your business’s needs based on your goals and current financial situation.

Invoice Factoring Is Just One Option

Invoice factoring allows your business to borrow against your accounts receivable without having to spend weeks applying with lenders and negotiating terms. Once you factor your invoices, you’ll get the capital you need in a lump sum payment to help you invest in your business immediately.