Invoice Factoring 101: Everything You Need to Know

Katie Horne
Last Updated on October 21, 2020
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Many small businesses find it impossible bridge the gap from where they are now to taking on lucrative B2B or B2G (business-to-government) contracts.

  • Such contracts are usually based on 30-, 60-, or 90-day payment terms.
  • The small business owner often needs working capital to pay for additional staff or equipment in order to service these larger contracts.

Sounds like a chicken-and-egg problem, right? But what if you could get cash from these new contracts as soon as you generated an invoice?

Well, you can. This process is called invoice factoring. Let’s find out how it works, how much it costs, and whether it’s a good fit for you.

What Is Invoice Factoring?

Invoice factoring is a unique form of business finance where a third party firm purchases your outstanding invoices for immediate cash minus a fee.

The purchaser is variously called a factor, a factoring company, an invoice factoring company, or an accounts receivable (or “AR”) financing company.

Factoring turns your unpaid invoices into working capital.

How Does Invoice Factoring Work?

invoice factoring process
Infographic by Digital.com

After applying for and being approved for invoice factoring you’ll receive anywhere from 70% – 95% of the value of your invoice(s) deposited directly into your business bank account.

Some factoring companies can provide same-day funding if the application and underwriting is completed before noon.

More commonly, funds can be received between 24-72 hours. (Not all factoring companies deliver fast funding: some take days or weeks to deliver.)

Your customer will receive a “Notice of Arrangement” directing them to pay their outstanding invoice, once due, to the factoring company.

Once payment has been made, you’ll receive the remaining amount of the invoice minus the factoring fee.

You may apply online for factoring or request a phone meeting first.

During a phone meeting, the factoring representative will answer your questions and and seek to qualify you for factoring.

construction
Invoice factoring is available to dozens of industries including construction, trucking, medical equipment supply, restaurant and beverages businesses, manufacturing, and import-export businesses.

How Do I Qualify For Factoring?

Invoice factoring is sometimes referred to as a factoring loan. However, it’s not a loan. Indeed, it’s one of the few forms of business financing that adds no debt to a business.

The qualifications for factoring differ considerably from business loans. The latter rely on your personal and/or business credit score and, often, the quality (sometimes called the “depth”) of your personal credit.

Creditworthiness of Your Customer

Approval for factoring — which is for businesses that sell B2B or B2G —  is based chiefly on the creditworthiness of your customers.

After all, they’re the ones who will be paying the invoice.

Average Monthly Revenue

The factor will inquire about your average monthly revenue for at least the last 3 months. Factoring firms typically require a minimum average monthly revenue.

For example:

  • Paragon Financial requires a minimum $30,000 in revenue per month and focuses on fast-growing businesses.
  • BlueVine requires at least $10,000 per month in revenue.
  • Fundbox, which offers a slightly different twist on factoring (called “invoice financing”), requires $50,000 in revenue per year.

Freelancers can use Joust which offers easy invoice factoring for sole proprietors and those in the gig economy.

Time in Business

Unlike business loans that look at length of time in business, startups with only several months of revenue history can obtain factoring deals, even in seven figures.

Non-Recourse Factoring vs. Recourse Factoring

What happens if you sign a factoring agreement, receive immediate cash, and 60 days later, when the factored invoice is due, your customer goes bankrupt or becomes insolvent?

Most factoring firms — including BlueVine — offer “recourse factoring.” Recourse factoring holds you liable for the unpaid invoices even if you already spent the advanced funds. (For this scenario, BlueVine provides an installment plan option.)

A minority of factoring companies (estimated at 20%) — including Paragon Financial — offer what’s called “non-recourse” factoring which protects you from this liability.

Credit Risk Insurance

Specifically, non-recourse factoring is an agreement, contained within a factoring contract, that provides credit risk insurance on your deal. Should your customer fail to pay, you will not be liable for paying that invoice to the factoring company.

Some businesses use non-recourse invoice factoring specifically to obtain this protection. (Established factoring companies can leverage their stellar business credit to obtain credit risk insurance at very low rates.)

Non-recourse factoring may become more sought after in periods of economic uncertainty such as before or during recessions and during trade wars and currency wars.

We mentioned earlier, that invoice factoring is one of the few forms of finance that does not add debt to a business. That’s true, unless you choose recourse factoring and one of your customers fail to pay their invoice.

Spot Factoring vs. Recurring Factoring

Some factors like BlueVine allow one-time transactions to factor a single invoice. Others, like Paragon seek an ongoing relationship of at least a year.

Recurring factoring is sought by some firms because of the complexity involved in underwriting factoring deals. A recurring arrangement is what makes factoring worth it to the company.

The Costs of Invoice Factoring

There are a number of considerations that go into the invoice factoring offer that you receive. These include:

  • Your average monthly B2B sales.
  • The total amount of your accounts receivable.
  • The “advance rate” — or percentage that you’ll receive immediately. (This is usually between 80%-90%.)
  • The “factoring rate” or “factoring fee” which can range from 0.25% – 10% of the total invoice amount.
  • The amount of unpaid invoices you’ve incurred over the past few years.
  • The DSO (or Day Sales Outstanding, which is how long your customers take to pay).
  • Whether or not you receive a non-recourse agreement, which includes credit risk insurance.

Sample Invoice Factoring Calculation

Using the online calculator that Paragon Financial provides, we’ve created the following example.

A small staffing business with $30k/month in average monthly B2B sales has $75k in outstanding receivables.

  • They sign a factoring agreement which provides them with a 90% advance rate, so they receive $67,500 immediately.
  • Their factoring fee, which includes credit risk insurance, is 0.9%. This is multiplied by their average monthly sales: 30k x 0.9% = $270.
  • Their DSO is 30 days. The factoring fee is multiplied by the number of months in the DSO: 1 month x $270 = $270.

As a result of their factoring agreement, the business immediately receives $67,500 in working capital. Once the business’s client  pays the factor, the factor pays the remaining amount of the invoice — minus the factoring fee — to the business. In this case, the remaining amount is $7,230.

Let’s assume that one of the small business’s customers suddenly goes bankrupt, despite having a great payment history, and fails to pay a $20k invoice that was part of the factoring deal.

Because this contract included a non-recourse agreement, credit risk insurance protects the small business owner who does not have to pay the $20k to the factor. Or, put another way, the small business received payment on that $20k invoice (from the factor) even though the customer defaulted.

Here’s another example. A business with $60k in monthly B2B sales has $200k in outstanding invoices. They get an advance rate of 90%, and immediately receive $180,000 in cash.

Their factor rate is 1.4%. Their DSO is 30 days. Multiply the monthly sales figure $60k x 1.4%  to get the monthly factor fee: $840.  The business receives a total of $199,160 from their factoring agreement.

Look For Transparency on Fees

One of the hallmarks of a reputable invoice factoring company is transparency about their fees and an avoidance of “hidden” fees.

Because factoring agreements can be complicated, if you are factoring a significant amount, we recommend you have your accountant or lawyer review the factoring agreement before you sign it.

Pros and Cons of Invoice Factoring

Like all financing products, invoice factoring is designed to solve specific problems. It’s ideal for obtaining working capital to take on bigger contracts or to take advantage of opportunities with a short time window.

It can also help a business cover immediate operational needs like purchasing supplies, or covering payroll and overhead.

The Pros

  • It’s possible to obtain immediate cash (same day or in 24 hours) as soon as you generate an invoice.
  • You can reduce the uncertainty inherent in 30-, 60-, and 90-day payment terms.
  • The amount you can factor is almost unlimited: some businesses factor millions in invoices per month.
  • With non-recourse factoring you can obtain working capital without incurring debt or risk of debt.
  • Since the factor often takes over managing your accounts receivable you can save staff time that was previously spent on this and on collections.
  • Qualification relies more on your customer’s creditworthiness rather than yours, so you can benefit from their strong credit.
  • You can set up an agreement to have future invoices factored on a recurring basis.

The Cons

  • Some of the best-known factoring companies only work with businesses making a set minimum monthly revenue.
  • If you opt for a recourse factoring agreement (vs. non-recourse) you’re on the hook for any invoices that are left unpaid by your customers.
  • If you opt for a non-recourse factoring agreement you may need to commit to an ongoing factoring contract of at least 12 months.

Choosing an Invoice Factoring or Financing Company

We mentioned that you should choose a reputable firm for factoring. How do you assess whether the firm is reputable?

Here are some things to look for:

  • How long have they been in business for?
  • Are they past the $1 billion mark (or some other high figure) in financing invoices?
  • Do they have a reputation for diplomatic and world-class interactions with businesses’ customers?
  • Do they have verifiable and overwhelmingly positive customer reviews?
  • Are their factoring rates reasonable? (You may want to get more than one quote.)

You will also want to determine whether you desire recourse factoring or non-recourse factoring and whether you’d like an ongoing factoring set-up.

BlueVine and Fundbox

Here we take a closer look at two well-regarded invoice financing companies: BlueVine and Fundbox. BlueVine provides invoice factoring. Fundbox provides invoice financing. Let’s take a closer look at both companies and how they differ.

 BlueVineFundbox
Factoring Lines$5 million$100,000
Ratefrom 0.25%2% to 10%
Approval Speed24 hours or longerAs fast as a few hours (as claimed by Fundbox)
Application Requirements530+ FICO score
3+ months in business
$100,000+ in annual revenue
only B2B
Business checking account
2 months of accounting software activity
OR 3 months of business bank statements
only B2B
WebsiteVisit BlueVineVisit Fundbox

BlueVine

BlueVine is a provider of multiple fast funding options for businesses. BlueVine offers recourse invoice factoring up to $5 million. You can be approved in as fast as 24 hours.

During the application process, you may manually upload your invoices, or provide the business-related information BlueVine needs by syncing your accounting software.

If approved, BlueVine will disburse between 85-95% of the invoice value upfront, with the rest coming once the invoices have been paid.


bluevine invoice factoring


 

BlueVine’s minimum requirements for invoice factoring include:

  • A credit score of 530+
  • At least three months in business
  • $100,000+ in annual revenue

Your invoices must also be B2B (business-to-business); BlueVine does not work with B2C (business-to-customer) invoices.

Should your account remain in good standing, BlueVine does not interact with your customers at all.

Fundbox

Fundbox is a San Francisco-based FinTech company offering fast cash products to small businesses.

They provide what’s know as invoice financing rather than factoring. In this scenario, they don’t purchase your invoices, they front you capital via credit based on your invoices and cash flow.

To apply for invoice financing, you need to register an account and provide access to your accounting software. They use algorithms to assess your credit risk.

Fundbox promises a response in hours, and if you’re approved, you may be able to draw funds on the same day and receive the funds on the next business day.


fundbox invoice factoring


 

Fundbox’s application requirements are:

  • Ownership of a business checking account
  • Two months of activity in supported accounting software or three months of transactions in a business bank account
  • At least $50,000 in annual revenue

Like BlueVine, Fundbox only works with B2B invoices and does not engage with your customers if your account is in good standing.

However, Fundbox only offers factoring lines of up to $100,000, with a broad 60%-95% invoice coverage.

Specialty Factoring

Most factoring companies serve many industries, and yet may not be able to serve selected industries such as construction or medical. Check with your factoring company before applying to make sure they service your vertical.

You can easily find specialty factors online.

International Factoring and Supply Chain Finance

U.S.-based factoring services can provide financing for import-export deals, but only if one partner in the deal is U.S.-based and the foreign partner has a U.S. presence, such as a branch office.

For example, a U.S. exporter of food and beverages receives an opportunity to take on a new overseas client who has issued a large import order. The U.S. business doesn’t have the cash flow to fulfill this order and pay the shipping costs. Through factoring, they immediately receive the cash needed to fulfill the order.

Another example: A U.S.-based small manufacturer lands a deal from a retail giant like Walmart. To fulfill the purchase order they must pay for a large shipment of manufacturing materials from China.

Using factoring, they can get paid for the Walmart deal upfront, and easily order the necessary supplies from overseas.

cargo shipment
Invoice factoring, and its related products like purchase order financing, play an important — and increasing — role in international trade finance.

In what’s called “reverse factoring,” a company may initiate factoring for a purchase order sent to a supplier, so that the supplier has the funds to fill the order. Often in these deals, the supplier is a small outfit, and the company producing the purchase order is large. The order may be factored at 100% in these deals.

For import-export deals where neither party has a significant U.S. presence, you should consult the International Factoring Organization for recommendations. Many of the best international factor firms are based in the U.K. (such as Stenn International) or in Hong Kong.

FAQ

Below we’ve answered some of the most common questions we receive about invoice factoring. Do you have a question of your own? Please leave it in the comments below. We’d be delighted to answer it.

What is a factoring broker?

A factoring broker, sometimes called a factor broker, works as a matchmaker connecting business clients with a factoring service suited to their needs. They function in similar way to loan brokers. Good brokers will seek the best match for their clients, in order to ensure repeat business. The factor broker typically receives a small percentage of the factoring company’s fee.

What is factoring in the trucking business?

Factoring is a financial service whereby a factoring company purchases your outstanding invoices, payable on 30-, 60-, or 90-day terms, for immediate cash minus a fee. Many truckers are paid on net terms. If they don’t use factoring, they may wind up obtaining multiple personal credit cards to cover their operational expenses, which can create a debt spiral.

Are factoring companies regulated?

In the U.S. factoring companies, as with most alternative financing options, are not regulated by the government. To assess these businesses you can check their customer rating, whether they are in good standing with the local secretary of state they are registered with, and whether their website provides transparency on pricing and fees.

Alternatives to Invoice Factoring

Invoice factoring isn’t the only option available to you when it comes to obtaining fast cash. Other options you might consider include:

Merchant Cash Advance

This option is designed to solve urgent, short-term cash flow issues.

In this scenario, you obtain a cash advance from the lender in exchange for an agreed-upon percentage of future sales plus a fee.

Merchant cash advances (MCAs) are typically limited to 70% – 120% of your average monthly revenue. It’s possible to receive same-day funding (as with invoice factoring) or funding within 24-72 hours.

Typically, you’ll make daily payments over a short term to repay the advance.

MCAs are more expensive than invoice factoring. Indeed, MCAs are among the highest-cost fast funding options available.

They make sense in scenarios where the business owner, by receiving the MCA, can fix a critical problem or make far more from the advance than it costs.

Line of Credit

Via online alternative finance providers, it’s possible to receive an offer and pre-approval for a business line of credit within 24 hours. It can take anywhere from 24 hours to 10 business days to receive funds.

That’s considerably faster than receiving a business loan from a bank.

Credit Card Stacking

With credit card stacking, you receive access to an unsecured credit line that is the sum total of multiple cards.

It takes an average of 7-10 days to receive the new line of credit. Some credit card stacking services charge fees of up to 15% of the total for the service.

Summary

Small businesses can use invoice factoring to obtain the working capital needed to expand their business and close bigger deals; to take advantage of opportunities with short time-windows, and to solve cash flow problems.

Whilst BlueVine is a decent option for larger businesses, Fundbox’s less restrictive requirements may suit smaller ones.


Photo credits: Construction site by Scott Blake on Unsplash, via an Unsplash license. Port of Hamburg cargo ship by Julius_Silver on Pixabay via Pixabay license.

Contributing writer: Sherrie Gossett Contributing editors: Marko Csokasi and Sherrie Gossett

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