For many entrepreneurs, invoice factoring has an unsavory reputation as the payday lending of business financing.
There’s a good reason for that. Entrepreneurs who need quick financing often sign long-term factoring contracts with confusing terms, pay sky-high factoring fees and risk interference in their customer relationships.
These disadvantages can create big problems for small business owners. As an entrepreneur trying to build your business, you need access to financing to improve your cash flow, but at better terms and prices than many factors offer.
53% of small businesses experienced a funding shortfall in 2017
You’re not alone. Many businesses need credit on a consistent basis. A credit survey by the Federal Reserve Board revealed that 43 percent of U.S. small businesses sought external sources of funding in 2017.
An estimated 53 percent of small businesses experienced a funding shortfall that same year.
A shortage of bank funding
The challenge is that banks frequently reject small business applications submitted by entrepreneurs.
In fact, big banks declined 72.3 percent of small business loan applications, while small banks declined 49 percent of loan applications.
This creates a void between the demand for bank funding and the amount of funding supplied. Factoring exists to fill this gap and provide an alternative funding source to bank credit lines and asset-based loans.
What is factoring?
If you’re not familiar with it, factoring is a process in which a financing company, often called a “factor,” advances cash based on uncollected invoices.
This allows factoring clients to build cash flow instead of waiting 60 days or longer on customer payments.
Factors typically advance between 80 to 90 percent of invoice totals. It can seem like a quick, easy solution to meet cash flow challenges, but there are several downsides, as the factoring industry is filled with several inefficient and even predatory providers.
The two types of factoring companies
There are thousands of factoring providers throughout the United States. The sheer number of options for entrepreneurs can seem overwhelming. Generally, though, factors come in two types:
These brick-and-mortar providers usually focus on specific industries, such as the garment industry, temporary staffing, trucking, and manufacturing. While traditional factors advertise fast payments, the amount of paperwork involved in transactions can often bog the payment process down.
These financial technology companies are typically industry-agnostic. They leverage technology to gain an edge against traditional factors, In many cases, fintech factors are trying to create an entirely new approach to factoring.
Three major drawbacks of traditional factoring
Many business owners don’t understand that a traditional factoring company is very different from a bank. Banks follow specific steps in reviewing loan applications, including:
- Examining business financial statements
- Checking a credit report
- Requesting and interviewing company referrals
- Making a decision on an application
- Signing a loan or factoring agreement
Factoring companies typically work with small businesses and entrepreneurs in a faster, but less structured way, which can lead to the following drawbacks:
Drawback #1: Confusing contracts
Factoring contracts can be very confusing, sometimes by design. As a factoring client, it’s crucial that you, the small business owner, understand the terms and jargon associated with a typical factoring contract.
Here are some of the common terms:
- Term requirement: Locks your company into factoring a certain amount of your invoices (often all of them) through the factoring company for six months, a year or even longer.
- Monthly minimums: Requires your company to continue to submit invoices totaling a certain amount to the factor each month. If you fail to meet this monthly minimum, you must still pay this minimum fee.
- Customer or concentration limit: Limits how much of your funding can be used on invoices from a single customer.
- Additional reserve: Provides additional cushion for the factor in case you use too much of your credit limit. Many factors use this reserve money without supporting data in cases where you draw more than 90 percent of your availability.
- Factoring reserve: The amount of money the factoring company keeps after paying a cash advance on your invoice. If you get a 90 percent advance, the factor keeps 10 percent. Eventually—depending on the terms of the contract—you will get a portion of that 10 percent back, minus the amounts of uncollected invoices, as well as other fees and penalties, and the interest rate charged as part of the contract.
- Guarantee: Requires you to personally guarantee the advances your company receives in the event that your customer doesn’t pay the invoices that you have assigned to the factoring company.
- Ineligible invoices: The factoring company reserves the right to refuse any invoices you submit for any reason. Many factors exclude invoices from overseas customers, customers personally related to you and past-due accounts.
- Recourse or non-recourse: These two types of factoring determine whether you or the factoring company are on the hook for non-payment from your customers.
- Collection days: The amount of time it takes the factor to apply payments it receives. Also called “float.”
- Credit limit: How much in invoices (gross amount) the factor will purchase from you at any one time.
- Invoice repurchase: when and under what circumstances you have to repurchase invoices sold to the factoring company.
- Additional collateral support: Any additional collateral required for the factoring company to feel secure. This may include a lien on your house, office facility, or other assets.
- Fees and interest costs: When and how much you pay the factoring company for its services.
Drawback #2: Sky-high fees
Factoring fees aren’t easy to figure out. Typically, factoring companies charge a percentage of the invoice amount that you are factoring by the month.
It’s important to know that many factors may charge a higher rate for larger amounts of invoices. Typically, the longer it takes your customer to pay, the higher the rate. Rates can range from .5 to 5 percent a month, or even more.
Factoring fees are usually structured in two ways:
- Daily rate structure: The factoring fee increases every day a factored invoice is outstanding.
- Tiered rate structure: The factoring fee increases every 10 to 30 days an invoice is outstanding.
Many other potential factoring fees:
- Interest rate: In addition to the fees above, factoring companies generally charge an interest rate that masks the true cost to factor. Factoring companies will quote this rate as what you’re paying, such as “Prime + 1%.”
- ACH fee: A transaction fee for transferring funds to you via ACH. The industry range is $5 to $50 per invoice.
- Wire fee: A transaction fee for an immediate wire transfer. This can be as much as $200 or more.
- Lockbox or service fee: Some factoring companies charge a monthly account maintenance fee, while others charge this fee to your customers to pay their invoices with the factor through an online portal.
- Origination: An origination fee may be assessed when you open your account.
- Draw fee: A fee paid when you access funds provided by the factor.
- Online access fee: A fee charged to provide access to your account online.
- Monthly minimum volume fee: A fee charged when you don’t meet your contracted monthly minimum of factored invoices.
- Renewal fee: Typically a percentage of your overall line of credit that the factor charges when the line of credit renews.
- Unused credit limit fee: A fee charged for not using a certain portion of your credit limit.
- Overdue or collection fees: A fee for collecting late payments on customer invoices that you factored.
- Credit check fees: The factor may run credit checks on your customers, charging you fees for those credit reports and their analysis.
Drawback #3: Interference in customer relationships
When you use a factor, you most likely authorize that company to collect payments from your clients. In fact, most factoring companies require you to change the payments to their name.
Your and your staff likely have a personal relationship with your customers. They are comfortable with how you do business, or they wouldn’t be purchasing goods and services from you. They know how you’ve sent invoices and collected payments in the past.
When you turn your invoices over to a factoring company:
- You have no control over how that factor will collect on those invoice payments.
- Your customers may be subjected to robo-calls from the factoring company.
- Your customers might also be presented with unfamiliar invoices, personnel, payment terms and payment methods.
While the payment process between the factoring company and your customer may go smoothly, there is a chance that it might not.
Problems between the factoring company and your customers could put a strain on your business. That’s a risk you take when you send invoices to a factoring company.
Further, your payments, when paid to you, aren’t commingled with those of other businesses, which makes record keeping easier. This isn’t the case when payments are in the name of the factoring company.
In fact, it’s fairly common for factoring companies to mis-apply payments from your customers to another business, which means you still have to closely watch all payments and reconcile them on your end.
Imagine factoring—without the factoring companies
Despite these problems, factoring does fill an important need for American small businesses. To grow a business, cash flow is necessary.
Eliminating the problems associated with factoring companies—confusing contracts, sky-high fees and interference in customer relationships—would create a more positive outcome for entrepreneurs.
Fortunately, there’s a way to improve upon the invoice factoring process without the hassle of dealing with factors.