Many business-to-business (B2B) and business-to-government (B2G) companies have no problem making sales but still experience cash flow issues. While businesses that sell directly to consumers receive immediate payment for the goods and services they provide, B2B and B2G firms have to wait weeks or even months just to get paid.

Of course, during that time, they have business expenses to take care of, such as rent, payroll, supplies, and utilities. Plus, there may be great opportunities that business owners want to take advantage of, such as temporary discounts from their suppliers or high seasonal demand for their products.

In situations like this, some business owners resort to small business loans. But what if they don’t want to get into debt, find it hard to qualify for SMB loans, or need the money right away? What can entrepreneurs do to get their capital unstuck and funneled back into their business?

One option is invoice factoring.

What is invoice factoring?

Invoice factoring is a form of business financing where you can free up capital without selling equity or taking on debt. Instead, you get a cash advance in exchange for your outstanding invoices. It is also sometimes referred to as accounts receivables factoring, invoice financing, and accounts receivables financing.

This type of funding is only available to B2B and B2G companies that invoice their customers, such as firms in the manufacturing, transportation, and oil and gas sectors. Invoice factoring companies do not work with business-to-consumer (B2C) companies, other financial businesses, and companies that do not issue invoices to their customers.

How does invoice factoring work?

In a factoring transaction, there are three parties: the client (the company issuing the invoices), the client’s customer(s), and the factor (the company that provides funding to the client).

The client sends the customer an invoice for goods and services rendered. The customer has an obligation to pay the invoice while the client has a legal right to collect payment from the customer.

The client then sells the unpaid invoice to the factor, who gives him a certain percentage of the invoice value (usually 70%–90%) as a cash advance that can be used for whatever business purpose. The remaining amount is held as reserve.

The factor now owns the invoice and thus also has the right to collect money from the customer. After the customer pays, the factor deducts its fee from the reserve and the rest of the money is given to the client as rebate.

When it comes to invoice factoring, factors charge a weekly or monthly factoring fee and some also charge a processing fee, usually around 3%.

So, let’s say you have an invoice worth $50,000 due in 4 weeks, and you have a 1% weekly factoring fee, and that the contract also specifies an advance rate of 80% and a 3% processing fee.

That means you will get an advance worth $40,000 (80% of $50,000) and the factor will keep the remaining $10,000 as reserve. If the customer pays after 4 weeks, the processing fee will be $1,500 (3% of $50,000) and the factoring fee will be $500 per week (1% of $50,000), so $2,000 in total. You will thus get $6,500 as rebate. So, out of your $50,000 invoice, you get $46,500.

The associated fees may be higher than those of small business loans, but invoice factoring is better than SMB loans in some ways. For one, it is not debt. The entrepreneur does not have to stress about making enough sales to afford the monthly payments or possibly losing his collateral. The products or services have already been sold; he is just waiting for the payment.

Another advantage is that getting funding via invoice factoring is faster and easier. Some small business loans, especially conventional ones such as bank loans, are hard to qualify for, require a ton of paperwork, and take a long time to get approved. With invoice factoring, on the other hand, the invoice acts as collateral so if the client’s customers are creditworthy, the application is quickly approved, and the funds released in just a few days.

Just note that you can only use invoices that are not pledged to other loans, i.e. not used as collateral for other loans. Your company should also have no involvement in any serious legal or tax problem.

Bottom Line

Invoice factoring is a type of funding that is available to B2B and B2G companies that issue invoices to their customers. With invoice factoring, business owners can immediately get a cash advance by selling their outstanding invoices. The associated fees are higher compared to conventional business loans but getting financed is much quicker and easier.

 

*This is a collaborative post.