Invoice factoring is a way for a business to get money fast as an alternative to a loan and is a process where a company sells unpaid invoices to a third party called a factoring company for a discount versus the total invoice amount. The factoring company then collects the invoice total from the customer, so they make a profit based on the discount they got from the company that sold the invoice.
How much the factoring company pays for an invoice depends on the business credit score and the credit quality of the customer paying the invoice. Customers with better credit are more likely to pay, which lowers the risk for the factoring company. Customers with poor credit scores may be seen as more likely to not pay, increasing the risk of the factoring company.
The risk level determines the discount on the total value of the invoice and is called the factor rate. Factor rates are calculated with this formula:
- Cash from invoice factoring = Invoice amount x (1 – factor rate)
Factoring companies only pay the company selling the invoice a portion of the invoice’s total and keep the rest on reserve until the customer pays the invoice. Here’s how the math works if a business sells a $100,000 invoice at a 5% factor rate with a 90% advance percentage:
| Total cash from invoice = invoice amount x (1- factor rate) | $95,000 = $100,000 x (1 – 0.05) |
| Advance amount = total x advance percent | $85,500 = $95,000 x 0.9 |
| Reserve amount due = total – advance amount | $9,500 = $95,000 – $85,500 |
Invoices are assets (accounts receivable on the company’s balance sheet) so factoring an invoice is an asset sale and not new debt like a small business loan. This makes factoring a great option for new businesses that can’t qualify for traditional bank loans.
The process is faster than standard bank loans, so factoring is also a good funding option for large companies with plenty of credit when they want to move fast.
Whether you need cash now or are planning for the future, here’s how the invoice factoring process works, how it is different from regular business loans, how to use it based on your business objectives, and tips to avoid common pitfalls.
The Invoice Factoring Process
There are three steps in the invoice factoring process:
- Negotiate the factoring agreement.
- Assign the invoice and get the cash advance.
- Verify that the customer pays the invoice and receive final payment from the factoring company.
Process Step 1: Factoring Agreement Negotiations
These items determine how much money you get and how much risk you have if your customer doesn’t pay:
- Factor rate, advance percentage, and dilution percentage (if any)
- Recourse vs. non-recourse
Factor, Advance, and Dilution Percentages
The factor rate determines the discount versus the invoice total and is based on your customer’s business credit score. Customers with better business credit reports will get lower factor rates, so you can sell their invoices for more money.
But don’t rely on their credit report alone. Show the factoring company your own books that demonstrate how your customer has always paid on time and in full. This helps build the factoring company’s confidence in your customers’ creditworthiness to help you negotiate a lower factor rate. If the factoring company won’t go lower on the factor rate, try to negotiate a higher advance percentage, so you get a larger amount up front.
If your business has lots of returns or post-sale adjustments and allowances, factoring companies might apply a dilution percentage to your agreement. The dilution percentage is what lowers their risk of a lower invoice total after returns, chargeback claims, and other post-invoice sales discounts that customers may demand.
Pro-tip: To get a quick estimate of what a dilution percentage might be, use this formula: Estimated Dilution Percentage = (1 – Net Revenue / Gross Revenue)
If your accounting software doesn’t track net versus gross revenue, use revenue from your taxes for net and add back all returns, plus any sales discounts you gave customers, to make a deal for gross revenue.
Dilution doesn’t mean you get less money when your customer pays in full, but it does change how much you get up front in the advance. If your customer does not pay in full or returns items after you factored the invoice, the factoring company will withhold payment from the dilution percentage to avoid losing money.
Here’s how to figure out how much you get up front and after your customer pays the invoice with dilution:
Step 1: Calculate factor fee.
- Formula: Factor fee = Invoice amount x factor rate.
- Example: For a $100,000 invoice to a large customer with good credit and a factor rate of 5%, the factor fee = $100,000 x 0.05 = $5,000
Step 2: Determine total cash value for sale (factoring) of the invoice.
- Formula: Cash from invoice factoring = invoice amount – factor fee
- Example: Cash from invoice is $95,000 = $100,000 invoice – $5,000 factor fee
Step 3: Calculate cash after dilution.
- Formula: Cash after dilution = total cash value for sale x (1 – dilution percentage)
- Example: Cash after 2% dilution = $95,000 x (1 – 0.02) = $93,100
Step 4: Calculate cash advance paid up front.
- Formula: Cash advance upfront = Cash after dilution x advance percentage
- Example: 90% advance percentage means the factoring company pays you $83,790 when you sell the invoice = $93,100 cash after dilution x 90% advance
Step 5: Finalize payment due.
- Formula: Final payment due to you after invoice collected = total cash value from step 2 – cash advanced from step 4 – any withholding from dilution (the exact amount depends on your specific agreement)
- Example: If your customer pays the full $100,000 invoice, the factoring company pays you a final amount of $11,210 = $95,000 from step 2 – $83,790 from step 4 – $0 from dilution since they paid in full
Recourse vs Non-Recourse
Recourse versus non-recourse determines who takes the risk for a customer not paying. A full non-recourse agreement means you have no risk whether your customer pays or not. These are rare because it would mean you also have a 100% advance rate.
A full recourse agreement means you are responsible to repay all cash advances from the factoring company if your customer doesn’t pay. Most invoice factoring agreements have a hybrid where you share some of the risk like a dilution percentage.
Process Step 2: Assign Invoice and Receive Advance
The factoring company will deposit your cash advance when you finalize the invoice factoring agreement. You will assign the invoice to them, giving them the legal right to collect on it, similar to how you would sign a check over to someone.
You aren’t required to tell your customer about this, but they’ll get a notice of assignment from the factoring company. It’s a good idea to at least give them a heads up and avoid surprise or confusion that could damage your relationship with them.
Process Step 3: Verify Customer Payment and Amount Due from Factoring Company
Following up to make sure your customer pays is a good idea even if you negotiated a fully non-recourse factoring agreement because it helps to prevent any hiccups in the process. Your established relationship with the customer can help make sure they pay the factoring company on time, which helps you factor more invoices in the future since the previous ones had no issues.
Staying involved to verify your customer pays isn’t just a good business move. It also means you’ll know when they have paid the invoice, so you make sure the factoring company swiftly pays you the remaining amount due.
Invoice Factoring Differences from Small Business Loans
Both invoice factoring and small business loans get you cash to grow your business, but the similarities stop there, since they’re different types of financing. Invoice factoring means you’re selling an asset, whereas business loans mean taking on new debt.
| Invoice Factoring | Small Business Loan | |
| Provides cash to invest in growth | Yes | Yes |
| Offers a larger or smaller amount of cash | Smaller | Larger |
| Requires you to pay back a lender over time | No (unless you have a recourse clause in your agreement) | Yes |
| Has fees | Yes | Yes |
| Boosts your business credit score | No | Yes (when you make all payments on time or early and your lender reports to the business credit bureaus) |
| Impacts ability to get additional loans | Small impact | Small to large impact, depending on your debt ratios |
The requirement to pay back a small business loan over time means you have to plan for future cash flow, but with factoring an invoice there’s nothing to pay back. On the downside, that means factoring won’t improve your business credit score like a small business loan can, since nothing gets reported to the business credit scoring bureaus.
Because you’re not taking on new debt with invoice factoring, it won’t have much (if any) impact on your ability to get approved for future loans. A small business loan will change your debt ratios, which lenders use to determine your risk as a borrower. If the loan drops your ratios below lender minimums, it can prevent you from getting approved for more debt until the current debt is paid off.
Since invoice factoring is a different type of funding than a business loan, here’s when it will make sense based on your business objectives and financial situation.
Good Fit for Invoice Factoring
Invoice factoring is a good fit for situations where you can’t qualify for regular business loans or for when loans aren’t an option because the process of getting approved for a traditional business loan would not be fast enough for you to take advantage of an opportunity.
Factoring is a great fit for new businesses in growth mode or long-standing businesses going through a turnaround after a few rough years, because customer creditworthiness is what matters.
It’s also a fit when you have a strong business credit report and access to small business lenders, but you need to move fast, want to avoid changes to your debt ratios, or want to take advantage of rate differences in situations like these:
- Factoring invoices gets you fast cash for payroll. You can use this financing to spend on ads that drive more demand. Or you can make a time-sensitive investment vs. waiting on the traditional loan underwriting process.
- Your debt ratios are close to lender thresholds, so using invoice factoring gets you the funds you need without impacting your future financing prospects. You could also use invoice factoring to pay off some debt and improve your ratios before applying for a new loan.
- You may be interested in taking advantage of supplier discounts when factor rates are lower than early payment discounts (or lower than late payment penalties). Selling an invoice at a 2% factor rate to get a 4% supplier discount for early payment lets you keep the 2% difference.
Even though invoice factoring is good for these situations, there are common pitfalls to watch out for.
Pitfalls with Invoice Factoring
Invoice factoring pitfalls mean more risk and less money for you, but avoiding them is easy when you know what to look for. Agreeing to a low advance or high dilution percentage is one common pitfall that’s avoidable by using your own customer data to show how they always pay on time and are a low risk for a factoring company to collect on.
Don’t agree to an advance you feel is low even if you don’t need all of the cash advanced up front. This can cause problems if the factoring company dawdles on final payment and causes you to miss key cash flow needs. There isn’t an official number that makes an advance percentage low, so shop around to get a sense of what’s available.
Ignoring recourse clauses is another pitfall that happens with invoice factoring. Make sure to have your lawyer review the agreement to make sure it doesn’t contain wording that doesn’t explicitly say “recourse” but still makes you liable (or more liable than you thought) for non-payments by your customer. A surprise recourse demand that hits when you don’t have cash in the bank could force you into financial strain.
Causing a strained relationship with your customer is another common pitfall that happens after you sell the invoice and can be entirely out of your control. Since the factoring company owns the legal right to collect the invoice, you can’t control how many times per day they call your customer, what they say, or how they say it.
The potential for a factoring company to harass your customer is low, but it does happen. Get reviews from customers they’ve collected from in the past and not just companies that have sold them invoices.
One more common problem with invoice factoring is using it in the wrong way by ignoring time periods. Factoring an invoice at a 5% to pay off a loan at 10% interest sounds great, but can bite you in the wallet when the term of the invoice is much shorter than the payback period on the loan. Check this example:
- Factor $100,000 invoice due in 90 days at 5% factor rate.
- Pay off $95,000 loan balance at 10% interest with 2 years remaining.
Factoring the invoice will give you the $95,000 needed to pay off the loan, but you can’t compare the 5% factor fee to the 10% interest because of the time difference of 90 days for the invoice versus 2 years for the loan.
Factoring an invoice due in 90 days for a 5% factor rate means you effectively pay 20% interest per year. Here’s why:
- You get $95,000 now, and your customer pays the factoring company $100,000 in 3 months.
- That’s the same thing as paying $5,000 interest for 3 months. Interest of $5,000 over 3 months is the equivalent of $20,000 over one year.
- $20,000 in interest applied to the $100,000 base is a 20% annual interest rate.
Invoice factoring lets you save money from rate differences when the time periods are about the same, but convert everything to annualized numbers before making a decision to avoid this issue.
Invoice factoring gives you fast cash to fund growth, letting you focus on operations and execution rather than loan applications and underwriting follow-ups. It’s different from a small business loan because you sell an asset versus take on new debt, but when you avoid common pitfalls and negotiate using your own customer data to get a fair factor rate, it puts another financial tool at your disposal.
SmallBusinessLoans does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
