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Updated: March 27th, 2020
While borrowing conditions have been improving slightly since the financial crisis, obtaining a traditional bank loan is still notoriously difficult for small businesses. Alternative financing options have boomed as a result. In fact, the majority of young firms’ capital injections come from non-bank sources, including owner investment.
In this article, we will look at two non-bank financing options for small businesses: invoice financing and merchant cash advance.
There are two ways to use unpaid invoices to raise capital for your business.
Also called accounts receivable financing, invoice factoring is not a loan but an agreement in which you sell your invoices as receivables. A third-party funding source (factor), buys the right to collect on these invoices by buying them at a reduced price—typically with a 2-6% discount.
In invoice discounting, you take out a loan against the invoice assets, effectively borrowing money from an invoice discounting company against money you are owed. Because it is a loan, this method of financing comes with interest payments and fees.
Invoice financing works for companies that invoice other businesses, such as apparel, food and beverage, import and export providers, manufacturing, staffing, transportation and wholesale/distribution. It’s most beneficial for young companies (under 3 years old) in rapid growth, that are transitioning into traditional financing. Factors commonly fund distributors, staffing companies, trucking companies, and service and manufacturing companies.
Invoice financing is useful for smoothing seasonal fluctuations, managing payroll expenses, purchasing additional machinery and equipment, and transitioning to a new distribution model. It can also be a good stopgap measure when you sell to a larger company that takes a while to pay you back.
Factoring does not affect your credit score. Factors also take on a lot of your accounting responsibilities, helping you refocus the energy you would have spent on collections and credit checks. On the other hand, invoice discounting allows you to retain more control over your sales and credit, so that your customers don’t even have to know that you’re using a third party.
Because the age of receivables is a factor in how valuable they are, older receivables will earn less. Invoice discounting makes it very important to have well-established credit checking, sales ledger, and credit control processes. Financing costs can exceed 20% of the value of the invoices.
A merchant cash advance, or MCA, is a short-term loan based on a business’ monthly sales volume. Repayment is made through a fixed debit or percentage taken off daily or weekly sales. Credit card factoring is a type of MCA; the loan is based on a business’s predicted future credit card sales.
Businesses that collect payment via cash, checks or credit cards instead of invoices, have a high volume of sales, are relatively stable even though they may have a fluctuating cash flow, and need a short-term cash infusion to grow the business are good candidates for MCAs. These include restaurants, hair salons, and retail businesses.
Like a term loan, an MCA is intended for an investment that will increase revenue. It’s a stopgap measure for short-term needs that will directly serve to facilitate sales. Examples include a restaurant going over budget weeks before opening, a contractor needing money for materials and labor to win a huge job, a florist hired last-minute to serve a big event, and a doctor purchasing new equipment that will generate income from diagnostic tests.
MCAs have a quick application process and high acceptance rate. Funds are available within hours or days. A poor credit score does not automatically discount you. Repayment is incremental and automatic. Also, there is usually no set repayment schedule.
Advances generally cost between 20-40% more than the face value of the loan. There is little regulatory oversight of the industry, leaving it open for predatory lending practices. It’s also important that you know you can make the sales to pay it off in under a year, ideally 6-8 months
Invoice financing and merchant cash advances can be helpful for businesses in certain industries that are doing well but don’t qualify or can’t wait for a traditional term loan. It’s important to trust your funding source and understand the terms of your agreement, before jumping into these forms of financing. For the right businesses, at the right times, for the right reasons, these options are a necessity. For the rest, other options may be more appropriate.
Samantha Novick is a senior editor at Funding Circle, specializing in small business financing. She has a bachelor's degree from the Gallatin School of Individualized Study at New York University. Prior to Funding Circle, Samantha was a community manager at Marcus by Goldman Sachs. Her work has been featured in a number of top small business resource sites and publications.