CEOs looking for financing may not consider invoice factoring as an option. But for some businesses, factoring may be a great solution to jumpstart growth.
What is Invoice Factoring?
Invoice factoring is a cash flow management tool that can provide a business with a continuous source of operating capital from its accounts receivable, allowing a company to pay creditors promptly, meet payroll, maintain overhead expenses, pay taxes, or simply relieve the financial burden experienced during rapid growth periods.
More specifically, factoring entails companies selling invoices to a factoring company at a slight discount to the face value of the invoice. On the day the invoice is due, the factor pays the company some percentage of the invoice - and then when the factor collects the invoice some time later, it pays the remaining balance to the company, less the factoring fee. These essentially converts a company's accounts receivable into instant working capital.
Factoring doesn't mean necessarily mean your business is struggling. Business owners may use factoring to increase working capital and facilitate growth.
When Should You Consider Invoice Factoring?
Here are a few scenarios in which factoring might make sense.
Equity financing seems too expensive. Businesses that use factoring typically have around $1-50 million in annual sales - for many of these companies, equity financing might seem out of reach. You want to maintain control. The equity investor usually seeks a large percentage of the company at a low valuation and a variety of control and reporting elements from the entrepreneur who is running and building the company day to day. You worked hard to build your business, and if you sell equity, you have now injected partner management issues into your very busy day.
You can't get a bank loan. Most banks tend to focus on established and clean credit history. For many startup business or those in rapid growth mode, access to that channel is lengthy and often simply unavailable. Factors will work with newer businesses and those where the business or principal has background issues like tax liens or bankruptcies, or an operation that isn't profitable - situations that cause real problems for banks to finance. Even if you are approved for a bank loan, it may take months - factors can approve a company for funding in a week.
Your customers are fast payers. Factors focus on the creditworthiness of a business's customers when making a funding business, the longer it takes for customer to pay, the more expensive factoring is. Cost can be a factor if your company has a good portion of receivables that pay late, especially over 90 days.
Your business would benefit from back-office help. Factors can provide small businesses with services "beyond advancing funds to its customers." They can "become a quasi-back office for your company by handling aspects of bookkeeping, collections, and credit guarantees, often gently assisting in putting order in a sometimes disorderly or understaffed process at a smaller, growing company."
Before working with a factor, look into their reputation with customers. Some factors may be undercapitalized or over-leveraged. In addition, make sure you understand all the fees and that your factor provides full transparency into your invoice collections through web portal access into their accounting system or a comparable method, and that reconciliations are done frequently, preferably daily.
By Meghan Daniels, Axial Forum