Business Loans

How Does Small Business Invoice Factoring Work?

invoice factoring

Companies that work in the business-to-business (B2B) sector often face cash shortages. The company may have to pay for labor and supplies to complete a contract, but their customers may not pay for weeks (or even months) after the contract is complete. To keep bills paid and payroll funded, B2B companies often need short-term financing options that keep their cash position strong.

One less conventional form of financing is invoice factoring, which involves the sale of invoices to a factoring company. This unconventional arrangement allows companies to unlock their cash early even if the company has a limited or poor credit history. However, invoice financing can be more costly than other forms of business financing. Could invoice factoring help your business maintain cash flow and profitability?

Here’s what you need to know about it.

PART I: What is invoice factoring?

Invoice factoring vs. invoice financing
How the invoice factoring works
Recourse vs. non-recourse factoring

Part II: Pros and cons to consider

Is invoice factoring your best option?

Part III: Learn more

6 tips for comparing invoice factoring companies
Applying for invoice factoring
Alternatives to invoice factoring

PART I: What is invoice factoring?

Factoring isn’t technically a loan, but it is often grouped together with business lending products since its an important method for businesses to improve cash flow.

Invoice factoring is a financing arrangement where a business owner sells its company’s invoices to a factoring company in exchange for upfront cash advance. A factoring company is a type of commercial financing company that provide invoice factoring services including purchasing invoices, paying cash advances on the invoices, and performing collections duties. They may also be involved in other forms of commercial asset-based lending (such as invoice financing discussed below).

After you sell your invoices to the factoring company, it will collect payment from your clients, and pays itself a set fee. Then the factoring company remits the remainder of the payment to your bank accounts.

Jeffrey Goldrich, President and CEO of North Mill Capital LLC, a company that provides invoice factoring services, describes invoice factoring as a fast and flexible form of financing. “Your company could sell just one batch of invoices to a factor, or you could enter into a longer term relationship with contracts lasting three to six months.”

Invoice factoring is an important business financing arrangement, but the cash advance is only one part of the product. Invoice factoring companies also provide credit screening and collections services, and they may “insure” your invoices, and allow you to keep your cash advance even if your client fails to pay.

However, these added services might not be a benefit. Since invoice factoring involves selling your invoices to an outside company, your clients will often know that their invoices are the subject of a factoring arrangement (through a process called notification). When your customers learn that you are using a factoring arrangement, it could damage your business’ reputation. They may believe your business is in trouble since factor companies have traditionally been seen as a “lender of last resort.” Even more concerning, your customers may dislike dealing with an outside company during the payment process. Small business owners should very carefully consider the notification and collections practices of a factoring company before they commit to the arrangement.

Time to funding

Compared to other forms of business financing, getting an advance from a factor company can be relatively fast. “On average, you would be looking at about week between application and funding,” explains Goldrich. “If you’ve got invoices with liens or other types of encumbrances, it would take longer, but those are the exception rather than the rule.”

Invoice factoring vs. invoice financing

Invoice factoring is commonly confused with invoice financing. Although these two models of financing share similarities, they are not the same thing.

Invoice financing is a loan (normally a revolving line of credit) that a lender issues based on your company’s average invoice volume. In invoice financing, the invoices serve as collateral for the loan. Companies using invoice financing may choose to draw on their line of credit when they need cash, but they do not have to draw on the line when their cash position is strong enough to meet their current obligations.

To qualify for invoice financing, you generally need a strong business credit history and strong quality invoices. By comparison, invoice factoring is more readily available to companies with limited credit history or some form of financial trouble.

One reason that factoring is more readily available to companies with poor credit history is that factoring isn’t technically a loan. Instead, in invoice factoring, your company sells invoices to the factor. That makes it much easier for the factor company to extend advances to all types of companies, including newer companies or those with poor credit.

As Goldrich explains: “In invoice factoring, we’re really just evaluating the credit quality of your invoices. That means underwriting is faster, and you can usually have money in your account within a week if you have good quality invoices. The drawback is that factoring is generally more expensive than a line of credit backed by your invoices.”

These are a few of the most important differences between invoice financing and invoice factoring:

Invoice financing vs. invoice factoring
Receivables financing (also invoice financing) Invoice factoring
Primary Purpose Access to working capital is critical to bridge the period between cash expenditures and revenue collections. Obtain immediate cash for receivables and help businesses with collection efforts
Credit requirements Generally requires strong credit history, but there are some lenders who accept businesses with limited or poor credit. Yes, but the credit quality of customers matters.
Type of financing Loan (normally a revolving line of credit, but it could be a term loan). Sale of invoices
Will your customers be notified? No Sometimes (when yes, it is called notification factoring; otherwise, non-notification factoring).

Notification factoring usually involves writing a note on the original invoice stating that the invoice is subject to a factoring arrangement. The customer will be directed to pay the factor company. If the customer pays late, they may receive contact (collections calls) from the factor company.

Long-term contract customary Yes (generally short term, but up to five years) Varies by lender. Some lenders are spot factors, and will buy a small batch of invoices. Others factors require a long-term commitment.
Typical advance options Often 70-90% of invoice value (though up to full value of invoice in the case of certain online vendors). Varies by industry and credit quality of customers. Often between 75-90% of invoice value.
What happens if a customer doesn’t pay the invoice? Business owner must still pay the loan. Bank may cancel line of credit if too many customers default. -Depends on contract.
-Recourse factoring means the factor lender can seek payment if your client doesn’t pay.
-Non-recourse factoring means that you get to keep your cash advance if your client doesn’t pay.

How the invoice factoring works

The invoice factoring process is different than most forms of business financing: it involves selling your assets (invoice receivables) rather than borrowing based on some collateral or a promise to pay.

The primary reason most companies choose to engage in invoice factoring is to improve cash flow. Once an invoice factoring company purchases an invoice, it sends immediate cash (usually 75-90% of the invoice value) to the original company. Once the client pays the invoice, the factoring company sends the remaining invoice value less invoice factoring fees.

In addition to providing immediate financing needs, invoice factoring companies also provide important services for their customers. For example, some factoring companies evaluate the creditworthiness of clients, perform bookkeeping duties, and engage in collections related activities for unpaid invoices. If your company is too small to have a collections division, this can be an important value-added proposition.

Here’s how the invoice factoring process works:

Step #1: Create an invoice factoring agreement:

A company can approach an invoice factoring company to create a factoring arrangement. Although invoice factoring is not a loan, it’s important to understand the terms and conditions of the arrangement.

These are a few things you can expect an invoice factoring arrangement to include:

  • Which invoices will the company purchase? The invoice factoring company may purchase all of your invoices or just the invoices from clients it deems creditworthy. In “spot factoring”, you can sell just a few invoices to a factoring company rather than selling most or all of your company’s invoices.
  • What advance rate will you receive? The invoice factoring company will generally pay an invoice advance rate when it purchases the invoice. The advance rate will vary based on the creditworthiness of your clients, your industry, and other factors. Advance rates range from 75-90% of the invoice value.
  • Will the factoring company screen certain clients? Some factoring companies will only buy invoices from customers that meet credit requirements. This means the factoring company may interact with customers during initial screenings. You should know whether a factoring company will screen or otherwise interact with new customers.
  • What fees will you pay? In general, you can expect to pay an invoice factoring fee based off the size of your invoice. A factor fee of 2% refers to 2% of the value of the invoice.
  • Some factoring arrangements are based off a flat fee model where clients pay a flat fee no matter when the client pays its bill.
  • Other arrangements are based off a tiered-fee approach where the invoice factoring company charges more when clients take longer to pay. With a tiered fee approach, it’s important to know when the factoring company will charge an additional fee. For example, you may pay one fee for the first thirty days, and an additional fee for every ten days the client takes to pay.
  • What happens when a client doesn’t pay? Invoice factoring arrangements can be either recourse or non-recourse arrangements. In a non-recourse arrangement, the factoring company cannot seek financial compensation from you if your client fails to pay. Nearly three quarters of invoice factoring arrangements are non-recourse, according to the 2016 Commercial Finance Association’s annual survey. The remaining arrangements are either partial-recourse or recourse agreements where the factoring company can ask you to pay back the advance when your client fails to pay its invoice.
  • Will your clients know? The factor company may require you to notify your clients that you intend to sell the invoice to a factoring company. This is called a notification factoring arrangement. On the other hand, in a non-notification factoring arrangement, clients are never specifically told that their invoice has been sold. Businesses need to carefully manage their reputation and their customer relationships when they enter into a factoring agreement.


Step #2: Fulfill contract for customers:

Once you have an invoice factoring contract, you’ll continue to do work as usual for most of your customers. Your company will continue to accept and fulfill contracts from most of your usual clients.

Factoring companies generally don’t interfere with the daily operations of your company. However, if you have a longer-term factoring agreement, your factor company may screen new customers to be sure the new customer is creditworthy. You will be able to sell invoices from creditworthy customers to the factor company once you complete the contract and send the invoice.

Step #3: Invoice your customers:

In general, your company will issue the first invoice to your clients. Once the invoice has been issued, it is eligible to sell. You may need to include a short note explaining that the invoice is going to be subject to a factoring arrangement.

Step #4: Sell your invoices:

Based on the agreement you and the factor company established, you can sell (also called assign) invoices to the factoring company.

Please note — factoring arrangements sometimes require you to sell most or all of your invoices to the factoring company. If that is stipulated by your contract, you must sell certain invoices to the factoring company.

Step #5: Factoring company issues an advance:

As soon as your company sells its invoices, the factoring company will deposit the advance money into your company’s bank account. The advance will generally range from 75-90% of the invoice value. Many factoring companies issue the advance within one business day of purchasing the invoice.

Step #6: Client pays the invoice:

After you assign the invoice to the factoring company, your customer will pay the factoring company directly. If your clients don’t pay their invoice on time, the factoring company may engage in collections activities to receive payment.

Step #7: Factoring company charges fees:

Once the factoring company receives the full invoice payment, it will calculate and collect its fees. Remember, in many arrangements, the longer a client takes to pay, the more fees the factoring company will collect.

Step #8: Factoring company sends remaining funds to your company’s bank account:

The factoring company will collect its fees, and send the remaining balance to your company’s bank account.

Recourse vs. non-recourse factoring

When considering an invoice factoring arrangement, one of the most important conditions to consider is whether the arrangement is a recourse or non-recourse arrangement. Recourse factoring arrangements allow the factor company to seek repayment of its advance if your client fails to pay its invoice.

“True non-recourse factoring would be when the factor won’t come after its advance, no matter what,” said Daniel Rodrigue, National Head of Sales for Bibby Financial Services, a factoring company. “The reality is that most so-called non-recourse agreements have a lot of fine print. You need to be really careful with those.”

Goldrich clarified that most non-recourse agreements are only non-recourse if your customer cannot pay due to bankruptcy or other financial reasons. If your customer believes that you did not fulfill your contract or withholds payments due to a dispute, the factor company may still seek repayment of the advance.

Rodrigue urges business owners not to be afraid of recourse factoring.

“It’s generally going to have lower fees, and the factor company will want to make repayment as easy on you as possible. For example, they might take back a percentage over a series of upcoming invoices.”

Part II: Pros and cons to consider

Invoice factoring isn’t technically a loan, but it is a financing arrangement. That means it works better for some situations than others. Will it work for you? Here are a few pros and cons to consider.


Improve cash flow: The primary reason most companies choose invoice factoring is that it improves cash flow. Your company can receive an advance of 60-90% of the invoice value, right away. This means you don’t have to wait to pay your bills until your clients pay you. Rodrigue explains, “If you own a business and you’re wondering how you’ll unlock cash, factoring will give you a stable form of cash. Instead of adding to your debt and hurting your cash flow later on, you’ll get to utilize your own cash sooner.”

Guaranteed payment: Although every factoring agreement is different, non-recourse factoring arrangements guarantee that your company will get at least partially paid in the event that the client can’t pay for financial reasons. In a non-recourse agreement, the factoring company will allow you to keep the advance, even if the client defaults on its payments.

No collateral: Invoice factoring means you sell your company’s invoices. You don’t need additional collateral like equipment, land or cash to receive your cash advance.

Not a loan: Unlike most financing arrangements, invoice factoring isn’t a loan. This means your business may still qualify for small business loans or equipment financing while you have a factoring arrangement.

Outsource some business activities: Although arrangements will vary by company, factoring companies may allow your company to outsource business activities, including collections activities and some bookkeeping activities.

May get financing with bad credit: Your company’s ability to qualify for invoice factoring depends on the quality of the invoices rather than on your company’s proven ability to repay. That means that companies with limited or poor credit history may still qualify for factoring.


Potential damage to your reputation: Your clients may place a high value on dealing with you and your company. Selling invoices to a factoring company may put a damaging barrier between you and your customers, especially when a customer wants to resolve an issue. However, factoring itself may not be as damaging as it was in the past. According to Rodrigue, “In the past, factor companies had collection agents that were more harsh and matter-of-fact. Either you did it the factor’s way, or you were out. These days, we’re much more flexible. We want to work with our customers and their customers. Plus, in many cases, your customers may already be dealing with a factoring company in other areas of its business.”

Higher cost: Since factoring companies provide business services, invoice insurance and financing in a single product, it can be tough to compare factoring fees to other forms of financing. However, a factor company that charges 2% for a 30 day advance of 80% of the invoice is charging the equivalent of 34.4% APR (on the amount advanced).

Business to business invoices only: Most factoring companies only allow you to sell invoices that your company has issued to businesses. Business to customer style businesses may not qualify for invoice factoring.

Best terms reserved for ongoing contracts: In general, spot factoring (where companies sell just a few invoices to a factor) has higher fees than an ongoing factoring relationship. However, the ongoing factoring relationship means that your company will pay more in factoring fees over time.

Is invoice factoring your best option?

Is invoice factoring the right financing option for your company?

Do I value the insurance aspect of invoice factoring?

The most common form of invoice factoring is non-recourse factoring, which means your company will get to keep your advance, even if your customer defaults. Non-recourse factoring is a form of payment insurance as well as a form of financing. If you value the insurance aspect of the arrangement, the cost may be well worth it for you. On the other hand, a company that does not need the “payment insurance” may be able to find lower cost forms of short-term business financing.

Can I strengthen my cash flow without financing?

B2B companies often have to fund the upfront costs of fulfilling a contract and then wait weeks or even months to get paid. This makes cash flow a potential hurdle. However, businesses may be able to strengthen cash flow through actions like renting instead of buying equipment, negotiating on recurring bills, buying in bulk, and selling excess inventory.

Would hiring an internal collections employee be more cost-effective?

Small and medium-sized companies don’t always have the ability to create an internal “collections” department to be sure customers are paying on time and in full. However, companies with a sufficient volume of business may find that its more cost effective to train an employee to take on collections task. This arrangement also ensures that the customer interacts directly with your business rather than without an outside partner.

Will invoice factoring damage my customer relationships?

Before starting a factoring arrangement, consider how the change will affect your customer relationships. It’s possible that you may lose an important point of contact with your customers when you turn over collections to a factoring company. Before committing to a factoring arrangement, you should learn about the factor company’s collection practices. Ask questions like: How will the factor inform you if a customer has an invoice dispute? And, what do typical collections activities include?

Are the company’s margins high enough margins to remain profitable?

Invoice factoring fees make it easy to unlock your cash, but the fees can eat into your profits, especially over the long term. Companies that want to engage in long-term factoring should be sure that their margins are high enough to maintain a profit while paying fees.

Part III: Learn more

6 tips for comparing invoice factoring companies

If you think invoice factoring may fill a need for your company, these are a few tips to help you find your best possible rates and services.

  • Decide whether you want a longer-term contract: To get your best rates on factor financing, you have to sign a contract that includes a minimum quantity or amount of invoices. A larger contract will bring down the average cost of factoring, but it can lead to higher total costs. Spot factoring (where you sell just a few invoices to a factor) means a higher one-time fee, but doesn’t require a long-term commitment.
  • Get quotes from several factor companies: If factoring fits your company’s needs, you’ll want to compare multiple factor companies. Each company will give you a unique advance rate and cost structure. They may also have different terms regarding whether they seek repayment from you if a client doesn’t pay. The Commercial Finance Association keeps a directory of member providers who provide factoring services. You should also search online for the top factoring companies in your industry.
  • Seek transparent fees: After you get a quote, be sure to ask a representative a few questions. Be sure the quote includes every fee you’ll ever be charged. You may have to pay “set up” fees in addition to the ongoing fees.
  • Clarify the company’s recourse policy: If one of your customers defaults on its invoice, what will happen to you? Some factor companies allow you to keep the advance, but will not pay out the balance. In other cases, you’ll have to pay back the advance if your customer defaults. Most factor companies specialize in either recourse or non-recourse factoring.
  • Calculate total monthly cost: After you get a few quotes, you’ll want to decide if the fees are worth it to you. The easiest way to do this is to calculate a total monthly cost. To do that, start by looking at your fee arrangement. Let’s say your factor company charges 2% for the first 30 days and .5% for every subsequent 10 days. If your clients pay after an average of 45 days, you’ll pay an average of 3% of your invoices (2%+.5%+.5%) in factor fees. If you plan to factor $20,000 in invoices per month, you’ll pay 3% of $20,000 every month. This means you’ll pay $600 per month in factoring fees.
  • Calculate the cost per dollar advanced: In addition to calculating the total cost of factoring, calculate the cost per dollar advanced. Once again, you’ll need to know your average factor fee, but you’ll also need to know your advance rate. You’ll simply divide your average factor fee by the advance rate to calculate the cost of borrowing a dollar.

From the example below, you can see that the option with the lowest factor fee didn’t have the lowest borrowing cost.

Advance Percentage Average Factor Fee Total Cost Per Dollar
70% 3% $.0429
70% 2.5% $.0357
80% 3% $.0375
80% 2.75% $.0344

Applying for invoice factoring

The most critical information you need to apply for invoice factoring is up-to-date information on your accounts receivable. An accounts receivable aging report will contain most of the information you need to apply. If you’ve never created an accounts receivable aging report, you may wish to connect with a local Small Business Development Center where local individuals can give you free help in creating one.

Accounts receivable reports will contain the critical information that the factor company needs to decide whether they want to buy your invoices. However, you’ll also need to submit some other documentation to qualify for financing. For example, you may need to submit tax returns, your company’s articles on incorporation, customer lists, and information about the business owners with your completed application.

In addition to information about your company and invoices, your invoice need to meet certain quality standards. If you’ve got liens on your collateral, you will generally have to clear them before qualifying for factoring.

Alternatives to invoice factoring

When invoice factoring isn’t a good fit, businesses have a variety of other options. These are just a few small business funding options to consider.

Invoice financing: Invoice financing allows business owners to use their invoices as collateral for a loan or line of credit. While invoice financing can be more difficult to obtain (especially for companies with limited or poor credit history) it can be a lower cost way to get cash when the business needs it.

Unsecured business line of credit: An unsecured line of credit allows business owners to borrow money when they need it, and pay it back when they have it. Business owners only pay for the line of credit when they borrow money.

SBA guaranteed CAPlines: CAPlines are an Small Business Administration (SBA) guaranteed loans designed to meet seasonal or contract based cash needs. These loans can be used to finance the costs of specific contracts, provide seasonal lines of credit, or to provide short term working capital for companies that have accounts receivable.

Cash flow planning: In some cases, a great cash flow plan means that a business won’t have to take on additional financing. Local Small Business Development Centers can help you create a cash flow plan for free.

Is invoice factoring right for your company?

Invoice factoring can help your company improve cash flow without adding debt, but it isn’t without costs. Businesses considering invoice factoring should be sure to compare their options to be sure they are accessing capital at the lowest possible cost.


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