What Is Factoring in Business?

Bakery business owner working on a laptop

Waiting for outstanding invoices can cause your business serious harm. You might have to pass on a great opportunity or struggle with bills even though you’re owed more than enough money to cover the costs. Invoice factoring could help in these situations.

What is invoice factoring?

Invoice factoring is a type of business financing that you can use to quickly get paid for your outstanding invoices. With invoice factoring, you sell your unpaid invoices to a factoring company — called a factor. Somewhat confusingly, using a factor is also called factoring. As in, you factor an invoice by selling it to a factor.

When you factor an invoice, the factor gives you a portion of the invoice’s amount right away and the remainder, less their fee, when your client pays the invoice.

For example, you might deliver a product to a client and send an invoice for $10,000 with net-60 terms. Rather than waiting 60 days to get paid, you factor the invoice, and the factor sends you $7,000. After 60 days, your client pays the factoring company, the company sends you $2,500 and the factor keeps $500 as a fee.

Invoice factoring can help you avoid cash flow crunches, but you’ll need to weigh services, fees, and fine print that different factoring companies offer. Here are a few important terms to know:

Advance rate: This is the upfront amount you can receive for each invoice, which typically ranges from 70 to 90% depending on the factoring company, your industry, the amount you’re factoring, your business’ credit, and your clients’ credit. You might also qualify for higher advance rates if you keep working with the same factor.
Factoring fees: These are the costs you’ll pay to factor your invoices. The main fee is called a discount rate, which is what the factor charges when you factor an invoice. This fee may range from 1% to 6% of the invoice’s amount and could be a one-time fee or recurring payment depending on how long the invoice is outstanding. For example, you might pay 2% of the invoice amount every 30 days. There may also be other costs, such as annual fees, administrative fees, and account closure fees.
Recourse: Many factoring companies use recourse factoring, which means you’ll be responsible for unpaid invoices. Non-recourse factoring can be more difficult to qualify for and cost more, but the factor assumes the liability.
Notification: You might be required to notify your clients that you’re working with a factoring company. With non-notification factoring agreements, you can keep the arrangement private. In either case, the factor will be responsible for collecting payment from your client, which might include following up to inquire about unpaid invoices. With non-notification factoring, the factor might use an email address and branding to make it look like messages are coming from your company.

The factor will also be responsible for collecting payments from your client, which might include following up to inquire about unpaid invoices. For example, factoring companies might require you to factor every invoice you receive — even if you don’t need the extra cash right now — or charge a fee if you don’t factor a minimum amount of dollars in a month. There are also some factors that offer spot factoring, which gives you the flexibility to choose which invoices you want to factor.

What is the difference between financing and factoring?

Invoice financing, sometimes called invoice discounting, is similar to factoring because it also relies on your invoices. However, instead of selling an invoice to a factor, you use your invoices as collateral for a short-term business loan or a line of credit. Since you’re not selling your invoices, you’re responsible for collecting payments from your clients.

Unlike a traditional business line of credit, your credit limit amounts can depend on your outstanding invoices. Qualifying for invoice financing also might be easier than getting a line of credit with a lender, but the fees are often higher — in line with what you pay for invoice factoring.

Is factoring a good idea?

Invoice factoring can be a useful type of business financing. Consider the general pros and cons.

Advantages of factoring in business

You don’t have to wait on unpaid invoices: Factoring can give you fast access to the money you’re owed, which can help you cover bills and grow your business.
May be easy to qualify: Your business’ finances and credit, along with your clients’ creditworthiness, can impact your ability to qualify for factoring and the rates and terms you receive. Factoring is generally easier to qualify for compared to many other types of business financing.

Drawbacks to factoring in business

Generally, only available for B2B companies: Invoice factoring is typically only available for business-to-business (B2B) companies that send invoices to their customers and then get paid on terms — perhaps 30 to 90 days later.
Relatively expensive: Even if you qualify for low discount rates and fees, factoring can be more expensive than other types of financing.
Could impact your reputation: You might have to tell your clients that you’re factoring invoices, and the factor can speak directly to your clients. Depending on your industry and the factor, that could negatively impact your reputation with your customers.

Alternatives to small business factoring

Invoice factoring can help address cash flow problems, but there are also times when other types of small business financing might work better. Some of the common alternatives include:

Business line of credit: With a business line of credit, you can borrow up to your account’s credit limit when you need extra cash and only pay interest or fees if you take out a loan from your credit line.
Small business loans: Available as secured or unsecured financing, small business loans let you repay the amount borrowed over a predetermined term. Small business loans can work well for major expenses, such as real estate, vehicles, equipment, inventory, and new hires.
SBA loans: The U.S. Small Business Administration (SBA) partners with lenders to offer several types of SBA loans. Although they usually have a difficult and time-consuming application process, SBA loans may offer favorable rates and terms.
Small business grants: Grants are free money that government agencies and private organizations offer to small businesses. You’ll need to find and apply for options that you qualify for — there may be very specific criteria.

Many business owners need access to capital to start, run, and grow their businesses. Knowing about the different options, including invoice financing and factoring, can help you align your financing with your goals.