Invoice factoring is a very simple transaction that involves a business selling its outstanding invoices to a factoring company. The factoring company then collects on the invoice, when due, from the business’s customers. It seems like a very simple transaction, and it is, but the devil is always in the details.
The first devil is that many small business loans are disguised as factoring. The second issue to be aware of is the factoring relationship not fitting your needs. And lastly, you need to be free to exit a factoring relationship without penalty or major pitfall in your cash flow. If you’ve contemplated factoring invoices, read on to learn the right questions to ask as you talk to factoring companies. However a quick explanation of how factoring works is warranted before getting into the details of what to ask.
How Does Factoring Work?
Once you bill your customers, you technically create an invoice (also known as Accounts Receivable or A/R). The best way to distinguish this from being paid cash is that with cash you get paid now, whereas with A/R you get paid later. With factoring, businesses can sell their invoices to a factoring company, and obtain up to 80-90% of the invoice value now. A/R factoring accelerates the payment, effectively. Then later, when your customer pays the factoring company the full invoice amount, the factor will release the remaining 10-20% to you, minus their factoring fee.
A couple other useful points to note about factoring invoices: first, factoring companies will have you contact your customers about redirecting payment to them. Second, the mechanism used by factoring companies to factor your invoices on a monthly or weekly basis is known as a factoring facility. Lastly, the law governing these transactions is the United Commercial Code, or “UCC” for short.
Now that you have a general understanding of how factoring works, let’s get into some details.
Avoid the Devil: Ask the Right Questions
Asking the right questions will definitely help you get the best deal. Please note however that the word best is relative. What happens to be a good deal for your business might not be the best deal for another’s. Either way, asking the following questions will help you sort out the details of the deal to best fit your needs.
Question 1. Is your factoring recourse or non-recourse? (it must fit your risk appetite)
True factoring facilities are non-recourse, meaning that the factoring company assumes the risk of non-collection. If they purchase an invoice from your business and the customer paying that invoice goes “belly-up”, that’s a risk that the factoring company assumes if the deal is “non-recourse”. However with a recourse factoring facility, the mechanism is the same as a factoring facility (i.e. 80% up front, with a rebate, minus fees later), but the liability is like a small business loan.
If a customer doesn’t pay your factoring partner, and your deal is recourse, you will be obligated to help the factor obtain that payment. In the event you and the factor are unsuccessful at getting your customer to pay, the factoring company can force you to pay the invoice by “selling it back” to you. In this regard, the factoring facility is really a line of credit backed by receivables. Usually, given the extra risk assumed by the business (i.e. being forced to buy-back the receivable), the rates on recourse factoring are cheaper than non-recourse. Therefore this question is important to ask so you can gauge 1) whether the factoring facility is a a loan disguised as factoring and 2) what level of risk you’re willing to assume by obtaining factoring. This article is very helpful in distinguishing the two, and identifying the similarities.
Provided the factoring deal fits your risk appetite, it’s important to ask three questions to make sure it fits your needs.
Question 2. What is your advance rate? (it must fit your needs)
The advance rate is the percentage of the invoice value that you will obtain right away. Most of the time it is 80%, however in some instances it may be as high as 90-95% for certain industries. This is important because if you need the full invoice value up front, obtaining 80% won’t do you any good. As a simple rule of thumb for cash flow timing purposes, think of it conservatively this way: you will get 80% up front, and then 18% of the invoice value 30 days after it gets paid. The 2% is the average fee paid on invoice factoring.
Question 3. What are your fees? (it must fit your needs)
Average fees are about 2 percent. This is also known as the “discount value”. For example, if an invoice is $100,000, and the discount is 2%, then you will pay $2,000. The timing is that you will get 80 percent, or $80,000, up front. Then the invoice will get paid to the factoring company ($100,000). The factoring company will charge the $20,000 excess a $2,000 fee, and they will remit or rebate $18,000 to you 30 days later. The $18,000 is usually held as a buffer against potential losses. It’s important to pay attention to the fees amount because if you have very thin margins, you may actually lose money factoring. Another rule of thumb: the gross margins you make on each invoice must be greater than the factoring fee.
Question 4. What is the minimum term? (it must fit your needs)
Some businesses only need factoring for a very short term. Unfortunately, many factoring companies require you to sign up for 12 months. Therefore it’s important to ask if there is a minimum term commitment.
Question 5. Is there an early termination fee? (avoid the penalties)
If there is a minimum commitment and you decide to leave early or switch to a better factoring facility, it’s important that you ask if there is a termination fee. Many factors will have a termination fee if you switch to a competitor of theirs, but if you switch to bank financing or simply don’t need them anymore, they won’t charge you. Understandably so. Either way, you need to know whether you can get hit with an early termination fee. Ask if this can be waived. Most factors will be ok with waiving this for you, plus it never hurts to ask. The worse that could happen is that they say no.
Other things to Keep In Mind
- In need of a one-time infusion?Ask for spot Factoring or seek out a Merchant Cash Advance (MCA)
- Need more frequent, but smaller payments?Ask your factor if they can advance you in weekly installments.
- Looking for more than 80 percent of your invoice value? You may need to seek out other small business funding options, like a line of credit, term loan or MCA.
For a free introduction to the funder that best fits your needs, please contact us.