As a business owner, you might have faced this situation before: you allow your customers to purchase your products and services right away (cool!), but they don’t actually pay back until months later (not so cool)…. which inevitably slows down your cash flow (very not cool). While this can help you attract customers, it can also be a huge roadblock if you’re trying to grow and scale your business. That’s where invoice factoring can come to the rescue!
Invoice factoring is when you sell an unpaid invoice to a third-party company, called a “factoring company,” at a discount. The factoring company now “owns” your invoice, and will get paid by your customer.
Through invoice factoring, you can turn unpaid invoices into cash for your business right away, without the wait. While this sounds enticing, it’s also important to weigh the pros and cons and really consider if invoice factoring is right for you and your business. In this article, we’ll explain what invoice factoring is, how it works, and the cost.
How does invoice factoring work?
Invoice factoring allows you to get an advance of capital in exchange for your unpaid invoices. You can then use the money as working capital to hire new employees, expand your business, and take care of other expenses. Here’s a breakdown of the process:
- You provide a good or a service to your customer.
- You send an invoice to that customer.
- You sell the unpaid invoice to a factoring company.
- The factoring company pays you 80-90% of the invoice’s value.
- The customer pays the factoring company when they pay the invoice. The factoring company is responsible for following up with the customer if they fail to pay on time.
- Once your customer pays the invoice, the factoring company pays you the rest of your invoice amount, but keeps the factoring fee, which is usually between 1% to 5%.
When should you use invoice factoring?
Generally speaking, invoice factoring might be right for you if you’re struggling to build a strong cash flow due to invoices not being paid until months later.
You may be a good candidate for invoice factoring if:
- You invoice other business or government customers and have been doing so for at least the last 3-6 months
- You have unpaid invoices that are due in 90 days or less
- You plan to factor invoices only from customers who pay on time
- Your personal credit score is at least 530
Invoice factoring example
Let’s say you own a propeller hat store and sell your merchandise to a retail store. Your customer has agreed to pay you $10,000 in 90 days. Sounds pretty lucrative at first, but that’s three months of waiting to receive your hard-earned cash! That’s income you need for expenses, like rent and payroll.
So you decide to turn to a factoring company. For clarity, let’s call this fictional factoring company The Factoring Company (very original, we know.)
Let’s say The Factoring Company gives you 85% financing upfront based on the value of your invoices. This means the rest of the money, minus the factoring fee, is sent to you once the customer pays the invoice.
So, here’s how this looks in practice. You have issued a $10,000 invoice that is due in 90 days. This means The Factoring Company will advance you $8,500 up front (85%). When the invoice comes due, your customer will send the payments to an account that The Factoring Company sets up in your business’s name, and The Factoring Company will send $1,000 of the customer payment to you. The remaining $500 will be kept as a fee.
The advantages of invoice factoring
Here’s how invoice factoring can help you:
- Get paid faster: Getting paid upfront through a factoring company within a day or two is faster than waiting months for a customer to pay you back. Nothing beats getting that “just got paid” feeling faster.
- Better cash flow: Since you’re getting paid faster, your business cash flow speeds up too! This means more cash on hand to invest in and grow your business.
- Improved cash flow forecasting: If you’re waiting a long time to receive money for a service you provided months ago, it can be hard to predict how much cash is going into and out of your business. Invoice factoring makes your cash flow more predictable, so it’s easier to know how financially healthy your business is and even prepare for surprise expenses.
- Easy to set up: Getting a loan can be trickier and more complicated than using a factoring company.
The disadvantages of invoice factoring
So far, we’ve been setting up invoice factoring to be pretty enticing, but it’s not for everyone. It’s important to weigh these potential drawbacks before making a commitment:
- Expensive: Factoring fees can really add up. Plus, some factoring companies may also charge application fees or processing fees. It’s very important to make sure you can cover the cost of the fees and still turn a profit.
- Not right for your business: Invoice factoring is for businesses that use invoices, and whose customers are typically other businesses. Some factoring companies may also prefer to work with businesses with many customers, rather than just a handful.
- Commitment: Invoice factoring typically isn’t something you do once—factoring companies will usually want to handle a large number of your invoices and may require you to sign a contract.
- Bad customers: Factoring companies aren’t a quick-fix for trouble customers who aren’t great at paying you back on time. If your customers have bad credit or a bad reputation for not paying you back, the factoring company may charge you a higher fee or not work with you at all. Plus, if your customer doesn’t pay up, you’ll be responsible for paying the factoring company back at the end of the day.
- Third party: Don’t forget that the factoring company will interact with your customers, and may need to chase them down for payments. Make sure they’re professional and won’t sour your relationship with your customers.
Is invoice factoring different from invoice financing?
People often use the terms invoice factoring and invoice financing interchangeably, but there are some small nuances between them. Despite their very similar names, invoicing factoring and invoice financing are not exactly the same.
With invoice financing, you borrow money from a lender based on your unpaid invoices. The financing company will loan you the full value of your invoice upfront (so you get 100% financing upfront), which you will then have to pay back within a specified amount of time, along with the fee.
With invoice factoring, you actually “sell” the invoice to the factoring company, rather than receiving a loan.
The benefits for both are also the same: they both help you get your money faster and speed up your cash flow, which in turn can help you grow your business faster.
Moving forward with invoice factoring
Consider invoice factoring if you invoice your customers but need cash to tide you over until they pay. It’s a quick and easy way to get paid faster and speed up your cash flow, so you have more money on hand for expenses and the investments that help your business grow. But it’s also important to evaluate if invoice factoring is right for you, and weigh other strategies you can explore to get paid faster.
If you aren’t doing so already, another tip for getting your invoices paid faster is allowing your customers to pay you back online (rather than only through cash or checks). Giving your customers more flexibility and making the payment process as painless as possible encourages your customers to pay you faster.
Did you know that you can allow customers to pay you back directly on a Wave invoice through Wave Payments? Accepting online payments through Wave Payments helps you get paid faster, with customers typically paying you back in as little as one or two business days.
When you email your customers their invoices, all they have to do is tap the secure “Pay Now,” button and they’ll be able to pay you through debit or credit card, bank payments, or Apple Pay for as little as 1% per transaction.
Whatever method you decide to try, you now have all the facts you need to make the right decision for you and your business.
The information and tips shared on this blog are meant to be used as learning and personal development tools as you launch, run and grow your business. While a good place to start, these articles should not take the place of personalized advice from professionals. As our lawyers would say: “All content on Wave’s blog is intended for informational purposes only. It should not be considered legal or financial advice.” Additionally, Wave is the legal copyright holder of all materials on the blog, and others cannot re-use or publish it without our written consent.