By James Stefurak
While a small business loan or line of credit from a bank is typically the preferred route for obtaining financing, the reality is many businesses won’t qualify for these options. A lack of profitability or operating history, and bad credit are all common reasons that disqualify candidates. Consequently, many entrepreneurs are forced to swim with the sharks that devour hard-earned equity for working capital.
But there’s a small business funding option that doesn’t follow the traditional route, and provides funding without incurring debt or sacrificing equity. If you operate in the B2B space, consider invoice factoring.
What is invoice factoring?
Invoice factoring is the discounted sale of accounts receivable (outstanding invoices) to a third-party buyer (known as a factor). It’s a funding mechanism that’s been around for centuries—Greek merchants utilized the practice to finance lengthy shipping ventures.
Today’s factoring is the same concept, providing interim funding to a company until customer payment is collected. When a small business performs a service or delivers goods on credit, they invoice their business customer, and then wait for payment . . . and wait. This waiting can take 30, 60, even 90 days depending on the terms and the customer (known as the “account debtor”). In the meantime, your business has to make payroll, pay bills, buy inventory, and accept new projects. Such a cash flow deficit makes running a business very challenging.
Instead of waiting for payment (plus expending resources on collection efforts) your business sells the outstanding invoice to a factoring company, known as the “factor,” transferring your right to collect on the invoice.
How does factoring work?
Here’s an example. After some due diligence on your customer (credit checks, outstanding liens and lawsuit searches, etc.), the factor decides to advance you 90% of the invoice’s face value. The account debtor is now instructed to remit payment to the factoring company, not your small business. When the account debtor eventually pays the invoice, the remaining 10% balance is refunded to you, less a factoring fee of usually around 2%.
In this example, the transaction provided up-front funds could keep operations running smoothly. When the invoice was eventually paid, your business collected a total of 98% of the original invoiced amount, but cash flow was greatly improved.
Who factors invoices?
Factoring is generally conducted by those in the B2B space. It’s common among certain industries that offer credit sales or have lengthy delivery or project completion times. Subcontractors, truckers, staffing companies, food and beverage distributors, cleaning businesses, government contractors, and import-export businesses are traditional beneficiaries of factoring. As technology has caught up to this historic financing method, new businesses have begun online factoring, including medical billers, professional services (accountants and consultants), and even freelancers.
The internet has improved the factoring industry as a whole, decreasing overall costs for users. Greater transparency and availability of information has reduced credit service and other due diligence costs, while the electronic payment revolution has made funding faster and cheaper. Some businesses can get invoices funded directly with one click via their QuickBooks or FreshBooks accounting software.
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Benefits of factoring
Immediate cash flow. Cash flow is the lifeblood of small businesses. In fact, 82% of small business failures are the result of poor cash flow management according to a U.S. Bank study. Factoring provides expedited funding, often same day, that can be used to meet short-term liabilities. It can also provide the funds to capitalize on a supplier discount by ordering in bulk or pre-paying.
Financing without debt. Factoring is not a loan—it’s the sale of accounts receivable to a third party. As such, the funding comes without additional indebtedness; it is a great financing option when credit conditions tighten. The reason many small businesses pursue alternative financing in the first place is because they’ve been turned away by traditional banks due to bad business credit. But it’s the creditworthiness of your customer that matters to the factor, since they collect from them, not you. Invoice factoring provides collections services so you can get back to running your core business.
Credit risk management. In a “non-recourse” factoring transaction, the factor assumes the credit risk of the account debtor. While adding the non-recourse clause is slightly more expensive, it can be a valuable risk management tool if you have a high concentration of receivables with one customer (where their default could jeopardize your operations).
4 tips when factoring invoices
There are some potential drawbacks to factoring; here are a few tips to protect your business:
1. Don’t get locked into a long-term contract with a factor you don’t know. While it’s often true you’ll get better factoring rates with longer contracts, you should insist on a shorter, trial period first. If they won’t oblige, try another factor. (It’s becoming a very competitive space so use that to your advantage.)
2. Fully understand the contract before signing. This is where the majority of factoring complaints we uncover stem from. Like any contract, it’s likely full of confusing and unfamiliar language written in favor of the servicer.
Specifically, look for a list of items in the contract that the factor will NOT charge you for. While this may sound unnecessary, it’ll likely save you money at some point. There are factoring companies that will charge you for a particular service even if it hasn’t been disclosed. Having an attorney read through any financial contract is a good idea.
3. Look for a specialist. If you are a new entrant to an industry, consider a factoring company that specializes in that industry (not a generalist). If they do, chances are they already know your customer. Since the factor’s concerned with your customer’s credit worthiness (especially in a non-recourse agreement where it’s their money on the line) their credit checks will be more informative than what your basic due diligence yields. Consider it an early warning system.
4. Change payment terms to “net 20.” Finally, there’s an abundance of evidence suggesting the economy is in the latter stages of the business cycle. If you’re worried about a customer’s future ability to pay, pursue a non-recourse agreement. If a factoring company won’t offer non-recourse terms for a specific customer, it may be that they can’t access trade/credit insurance themselves. Chances are you won’t be able to either, so consider changing the payment terms to this customer to “net 20.”
Attorney Kenneth Rosen cites the “20-day” rule to collect from customers that file Chapter 11. Basically, when a company files for bankruptcy, those suppliers who delivered goods within 20 days of the filing date have priority (after “secured” claims). Rosen adds that even if your contract with the debtor dictates specific payment terms, they may be amenable if the customer is under duress.
If your fast-growing business is being hampered by late-paying customers, consider turning those outstanding invoices into net working capital. For the right business, factoring provides a smarter funding option-providing immediate funding and collections services without adding debt or surrendering equity ownership.
RELATED: How to Collect Money From Slow-Paying Customers
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