What Is Invoice Factoring?

Invoice Factoring Explained in Less Than 5 Minutes

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Invoice factoring is a type of financing in which a factoring company buys a business’s unpaid invoices, typically paying the business the majority of the invoice amount upfront. The factoring company then directly collects the invoice balance from the client (i.e., the debtor) and pays the business the remainder of the funds—minus a percentage of the total invoice amount, which the lender keeps as payment for the service.

As a small business owner, it’s crucial to understand your options in regards to receiving funds that are due. We’ll discuss what invoice factoring is, how it works, and why it’s an important concept to familiarize yourself with.

Definition and Examples of Invoice Factoring

Invoice factoring is a type of financing in which a business sells its unpaid invoices to a specialized factoring company and receives most of the money—typically 80% to 90%—upfront. The factoring company is then responsible for collecting the invoice payment from the client. Upon full payment of the invoice, the factoring company gives the business the remainder of the amount due, keeping a portion of the funds as a fee for the transaction.

  • Alternate name: Accounts receivable factoring

For example, a floral shop might want to turn to invoice factoring to bill you if you have a large unpaid invoice for your wedding flowers. As the client (or debtor) in this case, you would have 30 days (or Net 30) to fulfill your payment, but the business’s payroll must be completed before then. The business can sell the unpaid invoice to an invoice factoring company and receive cash for most of the invoice upfront. The factoring company is then responsible for collecting the payment from you. After the invoice is paid, the factoring company would give the business the remainder of the invoice balance, minus the fee for the service.

Invoice factoring is different from invoice financing. With the latter, the business itself is still in charge of collecting payment from clients, not the factoring company.

How Invoice Factoring Works

Businesses often turn to invoice factoring to increase cash flow or outsource the time commitment of following up with clients about payments. Invoice factoring companies usually pay around 80% to 90% of the invoice upfront and charge a fee of 1% to 5% of the full invoice amount.

Factoring prices can vary depending on the following criteria:

  • Nature of the industry
  • Average amount of receivables
  • Creditworthiness and reliability of the client
  • Days outstanding to receive payment
  • Number of clients that need factoring

Recourse vs. Non-Recourse Factoring

Perhaps the most common type of invoice factoring is recourse factoring. This is an agreement that the business has to buy back any invoices the factoring company is unable to collect payment for. However, while the business—not the client/debtor—bears the risk in recourse factoring, using this method is typically less expensive than non-recourse factoring, which is when the factoring company assumes all risk associated with the invoice.

Make sure to carefully read and understand the fine print in your contract with the invoice factoring company. Some companies may charge hidden fees or late fees.

Benefits of Invoice Factoring

When it comes to short-term financing, invoice factoring is one of the most cost-effective methods available. Businesses such as startups that might not qualify for traditional business loans and need to secure cash flow quickly can opt for this method. It’s usually fairly easy to get approved for factoring as the funds are essentially being secured by the invoice—approval depends more on your client’s reliability, credit, and payment history.

Let’s say a small startup business doesn’t have the resources to track down unpaid invoices and decides to turn to an invoice factoring company for help. It sells the factoring company an invoice for $2,000 and receives $1,700 upfront, which is 85% of the total invoice. The factoring company then receives the full invoice payment from the client and pays the startup an additional $200. This is the remainder of the invoice minus $100 for fees, which is 5% of the total invoice. For a fee of $100, the startup both improved its cash flow and eliminated the time commitment of following up with the client for payment.

Make sure the invoice factoring company you’re working with has good customer service. Its interactions with your clients are a reflection of your business, so you want it to be a positive experience.

Key Takeaways

  • Invoice factoring is a short-term funding option whereby a business sells its unpaid invoices to a factoring company. In exchange, the business receives upfront payment for the majority of the invoice.
  • The factoring company is then responsible for collecting payment from the client. Upon full payment, the factoring company pays the business the remainder of the invoice, minus fees for the service.
  • Businesses commonly use invoice factoring to increase their cash flow or when following up on invoices becomes too much of a time commitment. Invoice factoring typically leads to an easier approval process and quicker time to funding than traditional loans.
  • Make sure to read and understand all the fine print in your invoice factoring contract so there are no surprises when it comes to hidden fees or charges for late payments from clients.