When it comes to running a business, cash flow is king. If there is no money in the bank to pay the bills and your workers’ salaries, then you will find yourself in big trouble. It can be hard to have the right amount in the bank at all times when your margins are thin. Sometimes the answer is a loan of some sort to keep your accounts flush. However, loans are harder to come by as lenders tighten their standards and give out less money.
Luckily, if you run an invoice-based business, you have an alternative. Factoring is the process of selling your invoices to a third party who will then take on the task of recovering the owed amount. This means that you can have working capital right away, instead of potentially having to wait until the end of your invoice grace period to get paid.
Table of Contents
How Factoring Works
When you perform a service, you send an invoice. In normal circumstances, you put a due date on that invoice and wait for payment. Most businesses give a 30 day grace period, but you can set it at whatever you like that works for your clients. The issue is that for those 30 days, you don’t have that cash in hand. If you multiply that by however many invoices you sent out, it can add up. Because of this awkward timing, you might not have the cash in your bank to pay your employees and any bills you might have.
To solve this problem you can use a factoring company. When you issue an invoice, you send it straight to the factoring agency. They will then pay you the money owed on the invoice, minus a percentage for their services. It is then their responsibility to get repayment from the client.
Notification vs Non-Notification Factoring
Notification factoring means that there is little effort to disguise that there is a third party involved. The factor will send the invoices to clients, make collection calls, and request payments to be sent to their direct address. While the client might not notice if they aren’t paying attention, it is usually clear that there is a factor handling the invoice.
With non-notification factoring, it is less obvious that there is a factor. They will use a postal box instead for check payments so that the client does not know who they are mailing to. Any correspondence will be vague as to the source, or it could even have your business logo on it to look as if it is coming directly from you. This type of factoring is useful when you do not want your clients to know that you are using a factor.
Why Choose Factoring?
There are several reasons why you might want to choose factoring. It’s a perfect option for businesses that are worried about their liquidity on a regular basis. Many businesses that use factoring do so because they have been rejected by traditional forms of funding, such as business or government loans. Factoring provides an alternative in that it works like a series of small business loans as opposed to one large loan. It is also a good choice for a business that is seasonal or has uneven revenue periods and may need cash quickly. Startups that haven’t built up profit or savings can also benefit from using a factoring service.
If you want to pursue a non-factoring agreement, then it requires some extra scrutiny. Your clients must have good credit histories and be in little danger of missing payments. To be a partner of a factoring service, you need to have shown a history of accounts receivable data, invoice several hundred thousand dollars a month, and have been in business for at least two years. This last requirement is why non-notification factoring may not be appropriate for startups.
Factoring Agreements
How a factoring agreement is set up will depend on the factor, but they are usually pretty similar. In most agreements, the factor will pay out between 75-90% of the invoice as soon as it is issued. When the client pays the factor, the factor will then forward on the difference to their customer, minus the fee they charge for the service. This is usually no more than 3%. Many businesses are able to negotiate a lower rate if they have demonstrated good business performance. Factors tend to require clients to commit to a certain volume of invoicing each month, as well. If you are a seasonal business, you may be able to negotiate a more appropriate agreement, however.
Since they will be dealing with your clients, you want to make sure that you choose a factor with a good reputation. Do your research and opt for one that will work well with you and provide the service your clients deserve. Then you will have a reliable finance source alternative that will help you stay liquid every month.
