Your Full Guide to Small Business Invoice Factoring
It’s the small businesses that make the world go ‘round.
With hundreds of thousands of new startups opening their proverbial doors every year, businesses like yours are essential to the supply chain.
In order to compete with the mega-chains, entrepreneurs often turn to using a billing system that involves invoicing.
As a small business, you rely on a steady cash flow to keep your overhead covered. A delay in payment from an overdue invoice has a domino effect that could impact your working capital for months.
Invoice factoring is a simple way to get the cash you need to buy equipment, cover your bills, or keep those doors open — fast.
Before adding this solution to your small business financial strategy, let’s look at the essentials you should know.
We’ll also discuss alternatives like invoice acceleration.
1. Breaking Down Invoice Factoring
One solution to a cash flow crunch is to turn to invoice factoring.
Invoice factoring gives you money in hand like a loan, but the money is yours to begin with.
You’re not borrowing money.
Instead, a third-party factoring company steps in to pay you the invoiced amount you’re owed, minus their fees. Your clients still get their usual 30-90 day financing terms, but they pay the factoring company directly.
Most factoring companies pay in two installments.
The first is an advance of 70-90% of your invoice. The second installment covers the remaining balance of the invoice amount after the customer pays and the factoring company takes their fee.
Using Invoice Factoring to Improve Your Business’s Finances
Done right, invoice factoring (also called accounts receivable financing or debt factoring) can be a wise strategy.
This type of financing helps a struggling business get back on its feet or expands a profitable one and makes it even better.
Businesses that have multiple invoices outstanding at any given time can benefit.
Invoice Factoring in Action
Say your cash flow is tied up in 30- and 60-day invoices waiting on customer payments. You know you’re going to get paid, but in the meantime, your primary vendor has a massive blow-out sale. Discounts are happening on all your supplies, and you want to get in on the bargain.
Paying a factoring company a fee to get paid early on a few invoices is a cost-effective move if it means you save more by buying the sale items.
Another example is when a business is struggling and needs working capital to stay afloat. Sitting on unpaid invoices for 30+ days versus using a factoring company could be the difference between going out of business or keeping the doors open.
However, standard invoice factoring should never be a go-to way to finance your business costs.
Consider the math for a basic invoice factor transaction.
Average fees for a $1,000 invoice would be 10% of the profit, depending on the company.
At $100, that’s not horrible. Doing this monthly takes you to over $5,000 each year.
Change that number to 10% of a $10,000 invoice (or combined invoices), and you’re paying someone else $50,000 a year to give you the money you already earned.
If yours is the type of business where that number impacts your bottom line, factoring fees can be dangerous.
We’ll talk about a similar, but more cost effective alternative in a moment.
You may also like: How to Collect More Accounts Receivable [9 Tips]
2. Advantages and Disadvantages of Factoring
Any time you have to look outside your own business’s collections, there are pros and cons.
Whether it’s bringing in investors, taking out a loan, or factoring invoices, you have to consider the good and the bad when you need funds.
Why Factoring Invoices Works
There are plenty of reasons to start with invoice factoring rather than the bank.
For one thing, earlier payment on invoices opens you up to accepting large volume orders from other clients. If you don’t have the capital to fill the order and wait for payment, you could lose the profit and the client.
No long, drawn-out monthly payments will tie you down later. You get the money you’ve earned to take care of the obligation in front of you. When the transaction is over — it’s done.
Because the creditworthiness falls on the clients, there’s an easier approval process, too. The factoring company checks out the client’s credit history, not yours.
Borrower Beware — Factoring Has Some Disadvantages
Every invoice factoring company works with its own terms, and you need to scour the fine print before you sign a contract.
The first thing to watch for is the fee. Factoring an invoice can cost more than taking a loan out at your bank. You need money fast, and the factor capitalizes on that hurry.
Look for the factor rate/discount rate/factoring fee. This may range from 0.5% to 5% of the advanced invoice amount. The rate may accrue weekly or monthly, and if you have a lot of high-dollar invoices and clients that take their time paying, this adds up.
Even More Fees
You may also see initial startup fees, maintenance fees, processing fees, and other charges. Some companies have early termination clauses tacked on, as well as monthly minimum fees.
Make sure the terms don’t hurt you more than waiting for the payment to solve your cash flow issues would.
Recourse factoring is another concern. If the client doesn’t pay, you’re liable for the money, plus fees and interest.
One last word of caution:
Unless you use spot factoring, you can’t always choose the invoices. Some factoring companies require access to your accounts receivable and want you to sell all outstanding invoices.
Get started here and create your NowAccount today to see if you qualify for accelerated payments!
3. Invoice Acceleration Versus Invoice Factoring
Instead of factoring, many small business owners choose to use an invoice acceleration program through companies like Now.
Invoice acceleration is similar to factoring. You still get your money fast by selling outstanding invoices.
That’s where the similarities end.
Invoice acceleration knocks out many of the disadvantages.
Now’s Unique Invoice Acceleration Program
Now is a company started by small business owners, designed to help small-to-medium companies succeed.
With that mission in mind, we developed invoice acceleration as a way to get working capital into the hands of those who need it most.
When you work with Now as your invoicing solution, you get all the benefits of factoring without the hefty downfalls. At Now, we make our fees clear upfront.
There are several benefits of working with Now’s invoice acceleration program.
Here’s how it works:
- Your company delivers the goods or services you provide to your client.
- You start the application process and submit the invoice you would like to accelerate to NowAccount. The invoice is processed and confirmed without your personal credit involved.
- Once it’s approved, Now pays you the invoice amount, minus a 3-5% service fee off of the total. No hidden fees or penalties are waiting to crop up at the last minute with their factoring services.
With Now, you choose the invoices you sell, and you can also select non-recourse factoring options.
4. Other Alternatives Outside of Invoice Funding
Businesses that don’t invoice, or prefer an alternative method of financing, have options, too.
The problem with SBA loans and grants is that they can take weeks or months to get approved, and you can expect to spend hours filling out paperwork. The requirements are extensive, including minimum credit scores, time in business, and more.
Faster Money, Less Stressful Alternatives
If low-interest rates or free money don’t sound worth the headache, or you simply don’t have the time, these financial solutions may work better.
A Business Line of Credit
Most businesses don’t want to put their overhead and expenses on a credit card. The rates are too high, and it doesn’t make financial sense.
A business line of credit, however, is another story.
This lending solution works like a credit card in that you can borrow from a pre-determined limit any time you need funds. It’s a revolving amount, so if you pay it back, it’s available again until the terms of the credit end.
At that date, any outstanding funds must be repaid in monthly installments, just as you would a credit card bill. The interest rates are typically a little lower than a credit card payment, and you must pay the loan within a set time.
Short-Term Small Business Loans
As the name implies, short-term small business loans are lending solutions that have to be paid back quickly.
This type of business loan has a lot of advantages, the main one being that you can often have your funds within 24 hours. It’s easier to get approved for financing than with traditional loans, and approval happens within a few hours or days.
If paying off debt is important to you, the short-term loan works well. The average payment plan is 18 months or less.
Keep in mind that lenders who offer short-term financing usually charge hidden fees and higher interest rates.
Merchant Cash Advances
If you need money now and can’t get approved for other funding options, a merchant cash advance is a last resort option. This suggestion comes with a strong warning that these loans are costly and risky to get involved with.
A merchant cash advance (MCA) works like a short-term loan. The MCA provider advances the business owner a lump sum of funds. They repay the money as a percentage of the business’s future sales.
MCAs are tempting to many small and medium companies in a bind, needing immediate cash.
You get fast access to the loan amount, and the repayment terms are flexible. You can have bad credit and no collateral, and you can use the money for anything you want.
This sounds great — until you read the cons.
If you thought your credit card rates were high, they’re nothing compared to an MCA rate. Lenders charge 70-200% for the annual percentage rate, plus fees.
The only requirement for an MCA is that the business has to accept credit cards. This is due to the way payments are repaid to the company. The lender accesses your daily financial log and takes a percentage of each business day’s credit card payments, seriously impacting your cash flow until you repay the loan.
MCAs don’t go on your credit history unless you default, either. So, if you’re trying to build or rebuild your business credit, this loan won’t do the trick.
While it’s an unwise business financing choice to put your expenses on a credit card, it’s still smarter than going with a merchant cash advance. Yet, the financing option is there should you choose to use it.
When you need money fast for your small business, lenders are ready to help. If you’re searching for short-term loans or invoice financing companies, you’ll find them everywhere.
The key is to look for lending solutions that will solve your immediate problem, not create long-term difficulties.
If you have outstanding invoices, contact us to talk more about the easiest and fastest ways to get out of a cash crunch.
Create your NowAccount today to see if you qualify for accelerated payments!