While a small business loan or line of credit from a bank is typically the preferred route for obtaining financing, the reality is many businesses won’t qualify for these options. A lack of profitability or operating history, and bad credit are all common reasons that disqualify candidates. Consequently, many entrepreneurs are forced to swim with the sharks that devour hard-earned equity for working capital.
But there’s a small business funding option that doesn’t follow the traditional route, and provides funding without incurring debt or sacrificing equity. If you operate in the B2B space, consider invoice factoring.
What is invoice factoring?
Invoice factoring is the discounted sale of accounts receivable (outstanding invoices) to a third-party buyer (known as a factor). It’s a funding mechanism that’s been around for centuries—Greek merchants utilized the practice to finance lengthy shipping ventures.
Today’s factoring is the same concept, providing interim funding to a company until customer payment is collected. When a small business performs a service or delivers goods on credit, they invoice their business customer, and then wait for payment . . . and wait. This waiting can take 30, 60, even 90 days depending on the terms and the customer (known as the “account debtor”). In the meantime, your business has to make payroll, pay bills, buy inventory, and accept new projects. Such a cash flow deficit makes running a business very challenging.
Instead of waiting for payment (plus expending resources on collection efforts) your business sells the outstanding invoice to a factoring company, known as the “factor,” transferring your right to collect on the invoice.
How does factoring work?
Here’s an example. After some due diligence on your customer (credit checks, outstanding liens and lawsuit searches, etc.), the factor decides to advance you 90% of the invoice’s face value. The account debtor is now instructed to remit payment to the factoring company, not your small business. When the account debtor eventually pays the invoice, the remaining 10% balance is refunded to you, less a factoring fee of usually around 2%.
In this example, the transaction provided up-front funds could keep operations running smoothly. When the invoice was eventually paid, your business collected a total of 98% of the original invoiced amount, but cash flow was greatly improved.
Who factors invoices?
Factoring is generally conducted by those in the B2B space. It’s common among certain industries that offer credit sales or have lengthy delivery or project completion times. Subcontractors, truckers, staffing companies, food and beverage distributors, cleaning businesses, government contractors, and import-export businesses are traditional beneficiaries of factoring. As technology has caught up to this historic financing method, new businesses have begun online factoring, including medical billers, professional services (accountants and consultants), and even freelancers.
The internet has improved the factoring industry as a whole, decreasing overall costs for users. Greater transparency and availability of information has reduced credit service and other due diligence costs, while the electronic payment revolution has made funding faster and cheaper. Some businesses can get invoices funded directly with one click via their QuickBooks or FreshBooks accounting software.
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