There are two types of invoice factoring—recourse and non-recourse.
Each type of factoring has different advantages. The best choice depends on your company’s goals and how much risk you’re willing to take.
Here’s how recourse and non-recourse factoring work:
What is recourse factoring?
When you choose factoring, you agree to sell your invoices to a factoring provider, or “factor,” in exchange for an advance of between 80 percent and 90 percent of the invoices’ value.
The factor then collects payment on those invoices from your customers. Once payment is made, you’ll receive the balance of those invoices, minus the factor’s fee.
But what if some of your customers don’t pay? In a recourse factoring agreement, the factoring client (you) agrees to buy back any uncollected invoices.
That means the risk of non-payment falls squarely on you, the client—not the factoring company.
You’re on the hook regardless of the reason why the customer doesn’t pay. If a customer has credit issues, operational issues, or contests an invoice in any way, you must buy back that unpaid receivable from the factor.
What is non-recourse factoring?
Non-recourse factoring is the opposite of recourse. It’s an agreement in which the factoring provider takes on the risk of nonpayment from your customers in the event of customer credit problems (ie: a customer files for bankruptcy or goes out of business).
If one of your customers can’t pay an invoice, the factor has no recourse but to eat the value it extended to you on that invoice. You, the factoring client, are not liable for invoices that are unpaid due to credit defaults by the customer.
For companies that don’t want to be on the hook for nonpayment, non-recourse factoring is a lower-risk option.
The disadvantage of non-recourse factoring is that it’s more expensive and can be harder to obtain than recourse factoring. Many factors charge an additional .5% to 1% on invoices that are funded through non-recourse factoring.
Not all factoring companies offer non-recourse as an option. Those that do offer non-recourse often charge a higher transaction fee for that form of factoring.
What “non-recourse” really means
As you consider an offer from a factoring company, don’t assume that non-recourse factoring means you have no risk. Even in non-recourse factoring agreements, there are risks related to the quality of the good or service that you provide your customers.
For example, if you sell widgets to a customer that turn out to be defective, that customer is highly unlikely to pay you.
In that case, there are no factoring providers (or invoice insurance, for that matter) that will protect you from nonpayment by your customer.
The right type of factoring for your business
Non-recourse factoring is more favorable to the client because it shifts the credit risk from you to the factor. But it might not be the right fit for every invoice.
For example, if the receivables you’re factoring are for big brands like Amazon, Walmart or Costco, the chances of nonpayment on those invoices is very small. Why would you pay the extra expense of non-recourse factoring?
The ideal solution for your company may be to find a factoring provider that allows you to utilize both recourse and non-recourse factoring.
When to use recourse factoring
For customers that have strong credit and pay on time, you could use the less costly recourse factoring and assume the nonpayment risk.
When to use non-recourse factoring
For newer customers that have less-than-stellar credit histories, paying more for non-recourse factoring might be the safer approach.
Of course, your factoring company would have to be amenable to taking on the risk of less reliable (or less well-known) customers not paying your invoices.
The bottom line
Again, if you are able to secure non-recourse factoring for your receivables, make sure you understand what “non-recourse” means in the factoring contract.
Non-recourse factoring contracts only protect the factoring client in the event a customer files for bankruptcy protection or becomes insolvent.
If a customer disputes an invoice for any reason, you are still on the hook for the payment.
To learn more on how invoice factoring companies operate—and what to look out for in a factoring agreement—read our article, “The Three Biggest Disadvantages of Invoice Factoring Today.”