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Find a Solution Financial Solutions

Factoring: What It Is and How to Choose a Service

Credit: Atstock Productions / Shutterstock

If your business is short on cash, you might want to consider factoring. Invoice factoring is the process by which a business sells some or all of its outstanding invoices to a service, known as the "factor," for an upfront percentage of the total value. Then, as the factor collects the outstanding payments, it will return the remainder to the client, minus the pre-determined fee. Factoring can be a great way for businesses to access capital quickly and for a relatively low rate, but there are a lot of factoring services out there. It's important to choose the right factor to work with, or else this form of invoice financing can become quite risky.

Choosing a factoring service doesn't have to be complicated, though. Here are three things to consider when selecting one for your business:

  1. What type of factoring does your business need?
  2. How much of your outstanding invoices do you need funded and when do you need it?
  3. How much are you willing to pay?

We will help you answer these questions below, but if you already know what you need and just want to see our recommendations for the best factoring service, visit our best picks page.

The first step to choosing the right factoring service for your business is figuring out which type of factoring you actually need. For instance, do you need a factoring service that covers all of your outstanding invoices up front or will a partial payment suffice? Do you prefer to keep receiving payments from customers or will you hand collections over to the factoring company? And do you want to be held responsible to the factoring company if customers don't pay? These are just some of the considerations we'll cover below.

First, to help you better understand the many different types of factoring, here is an explanation of how factoring works, followed by a breakdown of the most common factoring services.

Factoring is an alternative method of financing that allows business owners to sell their invoices, or accounts receivable, to a third party, the "factor." Factoring helps to fuel growth by providing the funds necessary to keep businesses going while waiting for customers to pay for outstanding invoices. 

Here's how factoring works in real life:

EcoNuts, an organic soap nut retailer that appeared on Season 4 of ABC's "Shark Tank," was unable to secure an investment deal, but still had a large purchase order from a major retailer on the line. The company opted to work with factoring company BlueVine to successfully fill the order. [See Related Story: BlueVine Review: Best Bad Credit Factoring Service]

"When [EcoNuts] came to us, they were limited by their working capital they had on hand to meet that demand," said Edward Castaño, vice president of marketing at BlueVine. "They had so many outstanding invoices from TJX [parent company of TJMaxx, Marshalls, HomeGoods and the Sierra Trading Post], that it made it hard for them to fulfill orders."

According to Castaño, EcoNuts didn't have the cash to purchase the supplies and cover the salaries to fill the new orders, which put their growth trajectory at risk.

"[EcoNuts] used our invoice financing solution to unlock the cash trapped in their invoices to fulfill new orders and maintain their growth trajectory," he said.

Editor’s Note: Looking or information on factoring services? Use the questionnaire below and our vendor partners will contact you to provide you with the information you need:

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Typically, the factor pays you between 70 and 90 percent of your total invoice value (sometimes in as little as 24 hours). The company collects your customers' payments and forwards the remainder to you, minus its service fee. 

Before accepting your invoices, the factor will conduct due diligence to determine the creditworthiness of your customers and whether they will be capable of paying their invoices on time. This is an essential step, as the factor typically does not function as a collection agency. To qualify for most factoring services, your customers' accounts have to be in good standing. Some factoring services also consider other qualifiers, such as your annual revenues and how long you have been in business.

After accepting your customers, the factor reviews all outstanding invoices and inspects them for accuracy and completeness. If everything is in order, the factor typically requests payment from your customers by sending them a notice of assignment. This informs the customer of the service you're using and instructs them to send all future payments directly to the factor.

Once payment has been made, the factoring service transfers the remaining balance owed on that particular invoice to you. 

Although many factors operate as described above, not all do, particularly newer servicers that have launched new systems that are more accommodating to small businesses. Some factoring services are also far more nuanced based on an individual business's specific situation, while others resemble traditional loans that need to be repaid.

For instance, some factors will cover 100 percent of the total invoice value, and then charge you fees when you repay them. This way, you don't have to wait for customers to pay their invoices to get all of the money you need, and the factor isn't deducting fees from customers' payments or money you do not have. One such company is Fundbox, our pick for the best factoring service for very small businesses. [See Related Story: Fundbox Review: Best Factoring Service for Very Small Businesses]

Some factors also don't require a notice of assignment, so your customers never have to know you're using a factoring company. These factors allow you to continue receiving payments from customers as if nothing has changed, and then you forward the funds as repayments to the company, plus fees.

There are two main classifications of factoring services:

Recourse factoring: This is the most common, readily available and cost-effective type. In this setup, the factor funds your invoices but requires you to provide a refund on any invoices that remain unpaid past a certain amount of time. Since the business owner assumes the risk with recourse factoring, there is a wider range of competitive rates.

Nonrecourse factoring: This type of factoring releases the entrepreneur from any liability for delinquent accounts. Since the factor is willing to take on substantially more responsibility and legwork, this type of factoring is more costly. The creditworthiness of the client roster will be more closely scrutinized in nonrecourse factoring.

No matter what path you choose for your business, the fundamentals are the same.

"The bottom line is that [the business owner] wants to get paid for their work right away," said Kevin Gowen Sr., founder, president and CEO of AmeriFactors Financial Group. "The deal isn't over until the customer has paid the invoice and the check has cleared the bank."

Those in the market for a factoring solution should be aware of the different options, and discuss with an expert which one could be the best choice. Here are a few common subcategories of factoring designed to address specific business needs:

Falling within the recourse classification, this type of factoring leverages your accounts receivables as collateral to provide immediate funding. The factor may be willing to accept older invoices for a higher fee.

Invoice factoring allows decision-makers to turn accounts receivable over to a factoring service, which assumes the risks associated with uncollected invoices. The critical difference from other types of factoring is that it's similar to a line of credit. The factor offers immediate funding, which is secured by the goods to be manufactured using the capital provided.

A hybrid of factoring and a line of credit, accounts-receivable discounting has two different varieties. In the first type, the lender provides a short-term loan using accounts receivables as collateral. The second type is similar to nonrecourse factoring in that the lender will actually purchase the invoices and will be responsible for collecting them.

Combining nonrecourse factoring with debt-collection services, a debt-factoring service assumes responsibility for uncollected invoices, immediately providing partial funding on the invoices while eliminating bad debt. This type of factoring can be more costly than others, as the factor will first explore your business operations to assess the difficulties involved in collecting on your receivables.

This type of factoring relinquishes more control of the accounts receivables to the factor. The factor manages the invoices, customer credit, payment schedule and provides funding (less the discount rate) on all invoices as they come due, whether or not the customer has actually remitted payment.

Another form of nonrecourse factoring, this type advances the entire value of your invoices, less the discount rate, up front. The factor assumes all liability for collecting debts.

Bulk factoring provides financing based on the total value of accounts receivable. Also known as in-house factoring, it allows you to take advantage of the financing opportunities of a factoring service, but maintain control of all operations related to your accounts receivables.

Generally speaking, the more risk the factor is taking, the more you'll likely have to pay for a factoring service. Fees are usually between 2 and 6 percent of the invoice total. This fee is known as a discount rate, and your specific rate will be determined by your invoice volume, customer base (individual consumers versus business clients), industry risk, client credit history and billing structure. 

Furthermore, how much you'll pay can also be determined by your repayment terms. For some factors, the costs add up the longer customers wait to pay. Other factors, however, allow you to prepay for invoices they covered and only charge you the discount rate on the outstanding amount.

For example, say a factor requires a repayment term of 90 days and charges you 4 percent in fees for $10,000 worth of invoices. If you or your customers take the entire 90 days to pay, you'll be charged the full 4 percent on the total invoice value of $10,000. But if you can pay $5,000 ahead of time, you'll only be charged 4 percent on the remaining $5,000 balance for the term of the financing. 

To get the best rates that fit your budget, find a factoring company that is experienced in your type of business and industry and offers pricing options that are specifically designed for small business. 

Those interested in factoring should begin with research. This includes determining whether factoring is right for the business, and if so, which service provider is the best fit.

"You want to work with someone that you trust and is transparent," Einat Steklov, president of Coral Capital Solutions, told Business News Daily. "It's good to ask questions. You want to work with a company that is experienced."

Steklov suggests asking contacts within the business community who can provide references for a great factoring company.

"You need to trust the person who makes the introduction for you, not unlike looking for a supplier that is critical to your business," Steklov said. "In the case of the supplier, you like to see the product when choosing it. When choosing a factoring company, you need to make sure they've factored before."

The potential downside to factoring is that the service fees may add up over time, and end up being more expensive than lending. However, the higher price may be worth it for immediate access to working capital.

It's important to view factoring as a financing strategy conducted over a period of time. Within this framework, realize that it can help you expand or recover while achieving specific long-term goals. 

Generally speaking, factoring is most beneficial to those with a reliable client base with a net 30 or net 60 payment structure. Factoring is not a solution for companies in dire financial situations. If your company has substantially more accounts payable than accounts receivable, factoring is probably not a good idea.

Factoring may or may not be the right fit for your business. However, if your day-to-day operations are suffering due to large outstanding invoices, the option should be considered.

"Overall, factoring is a simple finance transaction," Steklov said. "Factors want their clients to grow and be successful. Their success is our success as well, we grow together with our clients."

Ready to choose a factoring service? Here's a breakdown of our complete coverage: 

Additional reporting by Shannon Gausepohl and Adam C. Uzialko.

Editor’s Note: Looking or information on factoring services? Use the questionnaire below and our vendor partners will contact you to provide you with the information you need:

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Sara Angeles

Sara is a tech writer with a background in business and marketing. After graduating from UC Irvine, she worked as a copywriter and blogger for nonprofit organizations, tech labs and lifestyle companies. She started freelancing in 2009 and joined Business News Daily in 2013. Follow Sara Angeles on Twitter @sara_angeles.