Raising start-up capital is a major hurdle that most entrepreneurs grapple with when starting a new venture. Most financial institutions look at the creditworthiness of a company before lending money. Therefore, it is almost impossible for new businesses to get funding from a bank. Raising capital through venture capitalists is not easy either. Professional investors usually look for companies that have been in existence for some time and are already generating a profit.
Invoice factoring allows you to convert your unpaid client invoices into cash. This funding method is ideal for businesses whose clients don’t pay for services and goods immediately, but who require cash right away for business expenses.
So how exactly does invoice factoring work?
Invoice factoring is a kind of financing that involves selling your invoices or accounts receivables to a factoring company, which then gives you cash in exchange. The factoring company gets their money back when the customer pays, usually within 30-90 days.
Let’s say your company sells goods to a customer, generating a $5,000 invoice. The payment is due in 60 days, but you need the cash within two weeks to buy more stock. When you approach a factoring company, they agree to buy your invoice for $4,800 in cash – $5,000 minus a 4% factoring fee ($200). The company will then give you 85% of the invoice (or $4,080) within a few days, and the balance ($720) when the customer pays.
The factoring fee (discount rate) could range from 1% to 5%. It will be determined by your customer’s creditworthiness, your sales volume, the invoice amount and whether the factor is ‘nonrecourse’ or ‘recourse’. A recourse factor means that your company will be responsible in case the customer does not pay, while a nonrecourse factor means that the factoring company bears the risk of non-payment. As a result, a nonrecourse factor will involve a higher transaction fee.
Pros and cons of invoice factoring
- Quick cash – When you have slow-paying customers, invoice factoring offers immediate capital for running your business
- Easier approval – Invoice factoring is a great source of funding for businesses that cannot obtain capital from traditional sources due to a limited operating history, a poor credit score or lack of collateral. Factoring companies are only concerned about the creditworthiness of your customers.
- No collateral needed – You don’t need collateral such as inventory or real estate before getting funding via invoice factoring.
- Loss of control – Since factoring companies collect payment on the invoices directly, you need to ensure that your customers are treated fairly and ethically
- High cost – Invoice factoring could end up costing more than you bargained for. Look out for hidden fees such as credit check fees, processing fees, application fees and late fees when your customer pays past the due date.
- Customer’s weak finances or bad credit – As mentioned earlier, factoring companies usually check the creditworthiness of your clients. If the client has weak finances, or a history of missed or late payments, you might not secure the financing.
- Collection is not guaranteed – You cannot be absolutely sure that customers will make payment on all your invoices. A recourse factor will require you to replace the unpaid invoice with one of greater or equal value, or simply buy it back.
Though there are numerous invoice factoring companies out there, they are not all created equal. Look for company that has been around for a long time and is up-to-date with their business knowledge and offerings. The company should also have a good reputation with their customers. Finally, be sure to choose a company that offers competitive rates and agreeable terms.