What is Invoice Factoring and How Does It Work?

Invoice factoring is the act of selling the debt on one or more outstanding invoices to another business. The business that buys your invoice debt is called a factor.

The factor pays you an amount equivalent to what the invoices are worth, minus a percentage. The benefit is that you get paid sooner, giving you working capital to pay your bills. The drawback is that it reduces how much you ultimately get paid by your client. This is sometimes called “receivable financing” since you’re trading your accounts receivable for cash.

How does invoice factoring work?

To factor an invoice, it must have a term of 30 to 90 days. Generally, it takes two to seven days to qualify for invoice factoring, and another one to two days to receive payment from the factor. Sometimes factoring companies will check out the creditworthiness of your clients, too—they want to make sure they’re not dealing with people who won’t pay their invoices.

Here’s a super simple example. Let’s say you run a landscaping business. You’ve just sent your client Greg an invoice for $2,000, payable in 60 days.

Problem is, you need cash ASAP to buy a new leaf blower. So you factor Greg’s invoice. The factoring company gives you $2,000, minus a few percent to cover their rates. Now, you have the cash in hand. And once Greg pays his invoice, the factor will have their money as well.

How it differs from other financing options

Factoring is not considered a small business loan, because there isn’t anything to pay back. The onus is on the factor to collect the receivable and get paid.

And unlike a line of credit, it’s a one-time infusion of cash, directly related to invoices you agree to finance. A line of credit is an ongoing source of capital you can draw from when needed.

Invoice factoring rates and fees

Here are the common rates and fees you expect a factor to charge.

Invoice factoring rates

When you factor invoices, you can expect to receive about 80% of the value of your accounts receivable upfront. You’ll get the other 20%—minus the factor rate—once the client pays their invoice.

The factor rate (also called a discount rate) is a percentage of the invoice value, charged weekly or monthly. The industry standard is 0.5–5% per month.

A lot of factors have a tiered system. The longer your client takes to pay an invoice, the higher the factor rate.

Here’s a step-by-step example using Greg. This example doesn’t use a tiered system, and doesn’t take into account additional fees (discussed below).

You invoice Greg for $2,000, term 60.
You factor the invoice with ABC Factoring at a rate of 3% monthly.
Right away, ABC Factoring sends you $1,600. (That’s 80% of $2,000.)
After 60 days, Greg pays the invoice.
ABC Factoring sends you $280, the rest of the money they owe you. (That’s $400, minus 3% monthly for two months.)

All these fees will be spelled out in a factoring agreement, which you may be able to negotiate, depending on the vendor.

Other invoice factoring fees

In addition to the factor rate, factors may charge additional fees. Before you sign up for factoring, find out whether you’ll be charged any of the following:

New account fee. When you start a relationship with a factoring company, you’ll often be charged to open an account.
Renewal fee. If you have a contract with a factor, they may charge you each year to renew your account.
Collection or overdue fees. If the factor is forced to collect money from a client who is late, they may charge you a penalty. They may even charge you a flat fee for all late payments, whether they need to go through collections or not.
Unused line fee. If you have a factoring facility—an amount of usable factoring per month or week—your factor may charge you for failing to use all of it.
Monthly minimum volume fee. Similar to an unused line fee, if you fail to generate and pay a predefined minimum rate to your factor during the month, they may charge you a penalty.
Service or “lockbox” fee. When your clients pay their invoices through the factor, they may do it via an online interface. In this case, the factor may charge an extra operating fee for the digital “lockbox.”
ACH and wire fees. Your factor may pass on fees associated with either ACH or wire transfers—you can often get factor payments deposited directly in your bank account.
Credit check fees. If your factor does a credit check on your customers as part of setting up a contract, they may pass on the cost.

Choosing an invoice factor

When it comes time to choose an invoice factor, consider what is most important to you. For instance, would you be willing to sacrifice relationships with customers in order to get paid sooner?

That may or may not be a decision you have to make. Before signing any formal agreements with the factor, be prepared to ask the following:

How will the factor communicate with your clients? Will they robo-call them to remind them of upcoming payments? Or will they take a subtler approach? If you’ve worked hard to build up person-to-person relationships with your clients, consider how working with a factor may affect those relationships.
How long will it take to get funding? What’s the typical turnaround time for a factor to get you your money once you’ve submitted your accounts receivable?
Are you looking for non-recourse or recourse funding? You’ll be taking into account a different factor rate for each.
Are you looking for spot factoring, or contract? The factor may not offer both.
What’s the advance rate? While 80% up front is an average, the actual rate may vary from factor to factor. It could be as low as 70%, or as high as 90%.
What do they need so you can get started? Unlike a bank, most factors aren’t interested in your company’s financial reports. But what info do they need before you start factoring? They may be looking at your credit history, or the credit ratings of your clients. That could slow down the process of getting funded.
Are they familiar with your industry? It’s best to work with a factor who understands you industry, and works with other businesses in it. Plus, some factors only work with certain industries.
How long has the factor been in business? Do you know anyone else who has worked with them? Make sure you’re working with an established, trustworthy company—not some guy in a basement with a card table for a desk.

Invoice factoring vs. invoice financing

Sometimes the terms invoice factoring and invoice financing are used interchangeably. However, they’re two different financial services.

With invoice factoring, a factor buys your accounts receivable (the money people owe your business), assuming a certain amount of responsibility for them. That includes the responsibility to collect money from your clients.

With invoice financing, you still own your accounts receivable. The invoice factoring company just looks at it, calculates how much you’re expecting to get paid and when, and gives you a cash advance against that amount—typically around 80% of the total invoice amount, and the rest when the customer pays you (minus a percentage for their fee, of course).

Factoring costs less for you (the small business owner), but requires you to hand over control of your accounts receivable to another company. Financing, on the other hand, lets you hold onto your accounts receivable, but costs more.

Spot factoring vs. contract factoring

There are two different ways you’ll work with a factor: on the spot, or by contract.

With spot factoring, you make a one-off deal with a factor. This is good if you’ve only got a few invoices you want factored, but don’t want to make it a habit. The downside to spot factoring is that it usually costs more than contract factoring.

Contract factoring involves establishing a relationship with a factor, and factoring your invoices regularly. You’re typically covered for a certain amount of factoring you can “use” per period. This amount is called your factoring facility.

This is a good choice if you want to speed up your invoicing cycle, and make factoring part of your regular cash flow. It’s also cheaper than spot factoring. However, you have less freedom—your factor may penalize you if you don’t use a certain portion of your factoring facility every period.

Recourse factoring vs. non-recourse factoring

Let’s go back to the Greg example. Say you factor that $2,000 invoice, but once it’s time to pay, Greg stops picking up his phone or answering his email. The factor you sold Greg’s debt to can’t collect the money.

Now what? That will depend on what kind of factoring you’re using—recourse factoring, or non-recourse.

Recourse factoring

With recourse factoring, even after you’ve sold an invoice, you’re still liable for whether it gets paid or not. If the factor can’t collect on an invoice, you have to pay them the full amount. You may also need to pay a penalty fee. The recourse method is the most common type of invoice factoring.

Following our example, once 60 days has passed and Greg hasn’t paid, the factor comes back to you. They demand the full $2,000. Hopefully, you have it on hand. Otherwise it may be time to call ol’ Tony Soprano.

(Just kidding. Never call Tony.)

Recourse factoring means you need to make certain adjustments in your books. Any recourse you need to pay a factor must be tracked as a liability. We won’t get into detailed bookkeeping here—just know that, if you use recourse factoring and you’re a Bench client, we’ll take care of it for you.

Non-recourse factoring

With non-recourse factoring, you’re not liable for unpaid invoices. The factor buys the invoice outright, and assumes the risk of non-payment.

Sounds perfect, right? Naturally, non-recourse factoring comes with a couple of caveats.

First of all, because it’s riskier, factors will charge you more for non-recourse. The difference could be as much as a percentage point—say 3% of the amount you’re factoring, vs. 2% if you used the recourse method. And if your clients have a low credit score, those invoices might not be eligible for non-recourse factoring, since they’re a higher risk.

Second, you may still be liable. Every contract with a factor has its stipulations. It’s common for factors to only assume risk in case of bankruptcy. In that case, if one of your clients goes bankrupt, you’re fine. But if they dissolve their company and catch a flight to the Cayman Islands, you’re still on the line for the money they owe.

Invoice factoring is just one way to get immediate cash for your small business. And no, we’re not talking about loan sharks. There are at least seven (legal) ways to get cash, fast. However, factoring won’t solve underlying cash flow problems. Learn how to better manage your cash flow here.

This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.

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