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Updated: April 30th, 2021
About 225,000 new small businesses are established every quarter in the United States. While those small businesses may fall in a wide range of industries, from construction to beauty salons, they all share one thing in common — all require a steady flow of working capital. A common challenge many small businesses face is the delay between when invoices are paid and when new inventory needs to be purchased. Invoice factoring is a way for small business owners to take out a loan against unpaid customer invoices–it’s typically best for businesses whose customers do not pay for goods right away but need cash on hand to run their business effectively.
Invoice factoring is a way for business owners to quickly unlock funds from pending invoices for operational expenses as well as growth opportunities. Simply put, invoice factoring is when a business sells its accounts receivable to an invoice factoring company in exchange for upfront cash. With invoice factoring, you get paid by a factoring company, and the factoring company then gets paid directly by your customer.
This allows you to turn your accounts receivable into cash, rather than waiting as long as 90 days for customers to pay. Invoice factoring companies typically pay you in the following two installments:
Let’s imagine that Tiffany runs a residential staging company in which she’s hired by real estate agents to furnish and prep homes that are for sale. When Tiffany receives a staging assignment, she buys or rents furniture, artwork, and other decorations to give the property a specific look and feel which makes it more attractive to potential buyers.
While Tiffany charges an initial consulting fee, she generally gets paid on a monthly basis. However, every time a new client requests a staging, Tiffany needs to procure additional materials — and that requires a significant amount of upfront cash that she won’t see in her bank account for another 30 days.
By factoring receivables, Tiffany uses an invoice from a previous job and gets an advance rate of 70 to 90 percent of the total invoice within 24 hours. With those funds, she can avoid a cash crunch and keep a steady flow of capital to cover staging items and moving fees.
Let’s review some important pros and cons when it comes to invoice factoring.
It all boils down to two key questions:
In general, you may only want to factor an invoice if obtaining working capital right away outweighs its high cost.
There are over 700 factoring companies in the U.S and the list of requirements often vary based on the company. Here are the most common requirements that you may come across:
The key difference between invoice financing and invoice factoring is who is responsible for collecting payment from clients.
With invoice financing, you’re borrowing against your accounts receivables with these outstanding invoices serving as collateral. An invoice financing company lends you cash upfront and, upon receiving payment from your client, you pay back the lender the loan plus interest and applicable fees. Your business remains responsible for collection and continues to manage the relationship with your clients.
With invoice factoring, you’re selling your outstanding invoices, meaning the lender essentially buys the accounts receivables from you and takes over collecting from your client. The factor advances you a portion and sends the remaining balance (minus fees) after collecting from your client.
Another thing to keep in mind when comparing invoice factoring and invoice financing is the payment structure:
With invoice financing, you can be advanced as much as 100 percent of the outstanding invoices, but will be required to pay back the lender on a weekly basis over a set period of time — typically 12 to 24 weeks.
With invoice factoring, you’re advanced 70 to 90 percent of the invoice and repayment is based on how long your customers take to pay off the outstanding invoices.
Let’s explore the following scenario:
In this scenario, you would receive $19,995 [($25,000 x 80%) – $5 ACH fee] in a few days.
Your customer pays the invoice two weeks later.
After subtracting the 3% processing fee ($750), 2% factor rate per week ($1000), and $5 ACH fee, the factor pays you the remaining $3,245.
In the end, you only would see $23,240 from that original $25,000, costing you $1,760 with an effective APR of 183.04%.
Invoice factoring is best used to cover very short-term capital needs. With weekly factor fees and target collection periods of 90 days and under, invoice factoring is ideal for covering operational costs.
On the other hand, term loans are often used to finance larger growth investments which will lead to an increase in your bottom line. Common uses cases for term loans include opening a second location, hiring additional staff, or refinancing high-interest debt from credit cards.
Invoice factoring lets you sell your outstanding invoices to unlock funds that you need to run and grow your business. Receive up to a 90% advance on unpaid client invoices, and then get the rest of the money – minus the factor’s fees – when your client pays its invoice. Unlike some factors that lock you into restrictive contracts, Funding Circle’s lending partner offers “spot factoring,” meaning you can choose when and which invoices to factor.
Apply in as few as 6 minutes and your dedicated Account Manager will work with you to see if invoice factoring is a good fit for your business.
Louis DeNicola is the president of LD Money Media LLC and an experienced finance writer who specializes in credit, personal finance, and small business finance. Within the small business sphere, he helps business owners understand their financing options, cash flow management, business credit, and taxes. In addition to Funding Circle, you can find his work on BlueVine, Credit Karma, Experian, Wirecutter, and Lending Tree.