Invoice Factoring: How Factor Finance Works, Including Pros & Cons

One of the great ironies of running a business is that you can have great revenue figures, but still feel pinched on the cash flow side of things.

That’s because revenue doesn’t always equal free flowing cash – at least not immediately.

In many industries and business models, it can take weeks or months for invoices to be sent, paid, and cleared into usable cash for the business. 

It’s not uncommon for businesses to have five, six, or even seven figures worth of revenue tied up in invoices.

But what happens when you need this cash now? Is there a better option than patiently waiting for clients to settle up? 

Yes, there are answers.

And depending on circumstances specific to your business, invoice factoring – also known as factoring – could be the perfect solution.

What is Invoice Factoring?

Invoice factoring is a specific financing method in which business owners are able to quickly unlock revenue from pending invoices to be used for things like operational expenses and other growth activities. You can think of it like getting an advance on your pending invoices. 

how invoice factoring works

Invoice factoring works by selling your accounts receivable to an invoice factoring company in exchange for cash. This means the invoice factoring company pays you and the factoring company is then paid later directly by your customer. It’s a way of liquidating accounts receivable so that you don’t have to wait 90 days or more for a customer to pay.

Every invoice factoring company has slight nuances, but they generally pay in two installments:

  • The Advance: Typically, 70 to 90 percent of the invoice is paid upfront. (On a $10,000 invoice, this would be $7,000 to $9,000.)
  • The Remainder: The rest of the loan amount, minus fees and charges, is paid after the customer has paid their outstanding balance.

Invoice factoring companies work very similarly to debt collection agencies. When a credit card company needs to be paid faster, they’ll sell the debt to an agency. The agency pays the credit card company a percentage of the balance due and then becomes the one that the money is owed to. (It’s not a perfect example – especially when you consider debt collection agencies often pay pennies on the dollar – but it’s the same basic concept.)

Types of Businesses Where Invoice Factoring Works Well

Invoice factoring isn’t necessary for most businesses. However, there are certain industries and business models where it makes a lot of sense. Generally speaking, it’s a good fit for B2B companies where payment terms are between 30 to 120 days. You’ll also find it most useful if your business operates on a “final sale” basis, rather than a consignment or contingency basis.

The following industries are good candidates for invoice factoring:

  • Manufacturing companies
  • Wholesale trade companies
  • IT companies
  • Professional services
  • Oil and gas companies
  • Trucking and transportation companies
  • Staffing companies
  • Public relations firms
  • Construction companies

This doesn’t mean your business can’t use invoice factoring if you aren’t on this list. We’re just giving you an idea of the types of companies that most commonly use it. If you think you could be a good candidate, certainly look into it. 

Invoice Factoring Pros

Invoice factoring is an attractive option for several reasons. Let’s explore some of the biggest advantages that businesses enjoy when factoring:

  • Quick access to cash. You can typically get access to cash within as little as one to three days (especially once you have an established relationship with an invoice factoring company). This prevents you from having to turn down big orders or sacrifice growth opportunities because of constricted cash flow.
  • Easier approval. You’re not going to find many banks that will quickly and consistently lend to small businesses. And if you have less-than-excellent credit, you’re pretty much out of luck. With invoice factoring, none of this matters. Credit scores aren’t usually a factor (and you won’t have to worry about writing up a business plan or going through an underwriting process).
  • Better use of time. When you use invoice factoring, you’re able to spend your time on growth activities and value-adding investments (rather than chasing down clients and begging them to pay). This improved cash flow also has the added benefit of reducing your stress level.

Invoice Factoring Cons

As wonderful as invoice factoring can be, it’s not a perfect solution. (To be honest, there is no perfect solution other than having your clients quickly pay you in full.) Here are some of the negatives associated with invoice factoring:

  • High rates and fees. Invoice factoring companies don’t work for free. They charge rates and fees to offset the risk they’re taking. These costs can be relatively high when compared to traditional loans. The cost of borrowing is dependent on the factor rate (which is usually somewhere in the 0.5 to 5 percent per month range). The rate is dependent on factors like (a) the number of invoices you plan to factor and (2) the dollar amount of the invoices.
  • Recourse. In the world of factoring, there are usually two types: recourse and non-recourse. Recourse factoring is the most common. Under this type, you become directly responsible for the invoices if they go unfulfilled. That means if your customer fails to pay, you’re on the hook to pay back the factoring company on your own dime.
  • All or nothing. It’s not always possible to sell individual invoices (known as spot factoring). In most cases, you’ll be required to sell all of your outstanding invoices as one lump amount.

Should Your Business Use Invoice Factoring?

The decision over whether or not to use invoice factoring usually comes down to one simple question: Are you willing to give up 9 percent of an invoice (for example) in order to access 91 percent of the invoice right away?

If you believe that having faster access to a smaller amount is more valuable than accessing the full amount in several weeks or months, then factoring is a good fit for your business.

Invoice Factoring With InvestNet

Are you looking to exit your business? At InvestNet, we’re always searching for private company investment opportunities throughout the middle-market. Ideally, we’re in search of profitable companies in growing markets. If you think you fit that bill, please reach out!

Sky Richardson