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Factoring: What It Is and How to Choose a Service

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Invoice factoring is a form of alternative financing in which a business sells some or all of its outstanding invoices to a service, known as a factor, for an upfront percentage of the total value. Then, as the factor collects the outstanding payments, it returns the remainder (called the rebate) to the business, minus a predetermined fee. Factoring services primarily work with businesses that provide goods or services to other businesses or to the government, and use invoicing to bill their customers.

Factoring differs from traditional lending in that it's more accessible to businesses with less-than-perfect credit and there's no restriction on how you use the money. It's also faster: Applications are shorter and require less documentation, approvals are quicker, funding is provided promptly, and financing is repaid within weeks or months (typically 30 to 90 days) rather than years.

While rates are relatively low if your customers remit their invoice payments quickly, factoring can be more expensive than other financing options if your remittance terms are long, your customers are slow to pay or you need long-term financing. As you evaluate whether a factoring service can help your business improve its cash flow, consider the following questions:

  • Will this type of financing help your business grow?
  • How much does it cost to work with a factor?
  • Is there a contract? Are there minimums? What should you look for in a factoring service?
  • What type of factoring service should you use?

We'll help you answer these questions, 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.

Factoring can help you access capital quickly and is best used as a short-term solution that assists you in keeping your businesses running while you wait for customers to pay outstanding invoices, or allows you to take advantage of time-sensitive opportunities to help your business grow. For example, if you're waiting to receive payment on several large invoices but need money now because one of your suppliers is offering a significant discount if you purchase a certain dollar amount of products within a specific time frame, a factoring advance may be a good solution. Here's a real-life example of how invoice factoring helped a small business grow:

Eco Nuts, an organic soap nut retailer that appeared on Season 4 of ABC's "Shark Tank," was unable to secure an investment deal, but it still had a large purchase order from a major retailer on the line. The company opted to work with the factoring company BlueVine to successfully fill the order. [See Related Story: BlueVine Review: Best B2B Factoring Service]

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

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

"[Eco Nuts] 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 for 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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To meet eligibility requirements for most factoring services, your customers' accounts must be in good standing. Some factoring services also consider other qualifiers, such as your annual revenue and how long you've been in business.

The factor conducts due diligence to determine the creditworthiness of your customers and whether they're capable of paying their invoices on time. This is an essential step, as factors typically don't function as collection agencies.

After approving your customers, the factor reviews outstanding invoices and inspects them for accuracy and completeness, verifying with your customers that the invoices are genuine, the products or services have been received and accepted, and the invoice dates are correct. If everything's in order, the factor typically requests payment from your customers by sending them a notice of assignment that instructs them to send invoice payments directly to the factor.

After you've selected which invoices you want factored, the service advances you money, typically between 70 and 90 percent of the invoice value. Most companies transfer the money to your account using an ACH transfer, which can take around two business days to receive. Wire transfers are often available, though you'll pay a fee for the convenience of receiving your money the same day you request it.

After your customer pays the invoice, the factor forwards the remainder to you, minus its service fee.

"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."

Factoring fees usually range from 2 to 6 percent of the invoice total. This fee is known as a discount rate, and your specific rate will be determined by your creditworthiness, invoice volume and size, customer base, industry risk, client credit history, and billing structure. As with other financing options, the more risk the lender takes on, the more you'll pay in fees.

Rates may accrue weekly or monthly. When you call for a pricing quote, you'll want to ask whether it's a weekly or monthly rate and how frequently the rate increases. Some factors quote a monthly or 30-day rate that increases each additional 15 days, but many quote a weekly rate that increases every seven days.

Fees may be based on the advance or the full amount of the invoice. As you call for quotes, you also want to ask whether the fee is based on the full invoice amount or only the amount of your advance. As most companies advance between 70 and 90 percent of the invoice value, choosing a company that charges only on the advance saves you quite a bit on fees.

Factoring is expensive if you have long remittance terms or slow-paying customers. If you have long repayment terms or your customers tend to pay late, longer-term financing, such as a bank loan, may be more cost-effective than factoring. Although 2 to 6 percent sounds very low, keep in mind that this is only for the week or month, depending on the factor's terms. If you're quoted a 1 percent fee that compounds weekly and your invoice remittance terms are 30 days (around four weeks), you'd pay 4 to 5 percent – if your customers pay on time. If your terms are longer or your customers pay their invoices late, factoring gets expensive. For example, for a 60-day remittance, you'd pay 8 or 9 percent, and for 90 days, you'd pay 12 to 13 percent.

Some factors charge additional fees. Although the best factors only charge a percentage of the invoice advance, some charge a variety of fees. When you call for a quote, you want to ask the sales rep if the factoring company charges any of the fees listed below. You also want to read the contract or terms of service and to verify which fees the company charges before signing up for a service. Possible fees include the following:

  • Application fee: This fee covers the costs of reviewing your application, setting up your account and screening your customers.
  • Bank transfer (ACH) or wire fees: Most factors provide ACH transfers for free but pass the bank's wire transfer fee on to you.
  • Credit check fee: Sometimes included with the application or due-diligence fee, this fee for checking your customers' credit may be charged separately or when you bring on new customers (this may be called a new client fee).
  • Due-diligence fee: Similar to the application fee, companies may charge this fee for the costs involved with checking your credit and your customers' credit, and verifying that your customers and invoices are authentic.
  • Early termination fee: If you sign a contract and decide to close your account before the end of the term, you may be charged a penalty.
  • Lockbox fee: If the factoring service sets up a lockbox for your customers to send invoice payments to, you may be charged a fee.
  • Service fee: This fee may be charged monthly and covers costs associated with maintaining your account.

In addition to rates and fees, you'll want to ask the factoring service about its terms, including the following:

  • How long is the contract? Although some factoring services are willing to work with you on an as-needed basis, others require you to sign a contract. If this is the case, ask how long the term is, what your obligations are, if it automatically renews at the end of the term, what the cancellation procedure entails and what fees you'll incur if you close your account early.
  • Is there a reserve account? To mitigate their risk, some factors hold a portion of your invoice payments in a reserve account. For example, the factor may reserve 10 to 15 percent of your credit limit.
  • What is the monthly minimum? Some companies require you to factor a certain dollar amount or number of invoices each month. If you fail to do so, the company charges a fee to compensate for the money it expected to make from your account.

As you evaluate factoring services, you need to decide which type of factoring you need. For instance, do you need a service that factors all of your outstanding invoices, or do you want to choose which invoices to factor? Do you prefer to continue receiving payments from your customers, or are you comfortable handing collections over to the factoring company? Do you want to be held responsible to the factoring company if customers don't pay? Keep the following types of factoring in mind as you evaluate factoring services.

Bulk or whole-ledger factoring: With this type of factoring, you turn over all of your invoices to the factoring service for a set period. You're usually required to sign a contract, and there are typically monthly minimums and additional fees associated with this type of service. However, rates are usually lower.

Spot or single-invoice factoring: You can choose which invoices you factor with this type of service. There's normally no monthly minimum or contract requirement, but rates are higher. If you only plan to use a factoring service intermittently, or you only want to factor invoices from certain customers, this is the type of service to look for.

Recourse factoring: This is the most common, readily available and cost-effective type of service. In this setup, the factor funds your invoices but requires you to provide a refund on any invoices that remain unpaid after a certain amount of time. Since you assume the risk, rates are lower.

Nonrecourse factoring: This type of factoring releases you from any liability for delinquent invoices. However, since the factor assumes the risk of unpaid invoices, this type of factoring costs more and the creditworthiness of your client roster will be more closely scrutinized.

Notification factoring: The majority of factoring services require you to send your customers a notice of assignment instructing them to remit invoice payments directly to the factor.

Non-notification factoring: Some factors 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; you then forward the funds, plus fees, to repay the advance.

However, the factoring services that offer non-notification factoring may function a little differently from those that notify your customers. Your rates may be higher, there may be a repayment schedule, and late fees may be applied to your account if you fail to repay the advance on time.

For instance, Fundbox, our pick for the best factoring service for very small businesses, advances 100 percent of the total invoice value. You repay the advance, plus a weekly fee, over a 12- or 24-week term. The advantage is that you remain in control of your receivables and, if you can repay the advance early, you can save money, since there's no early repayment penalty. However, the prorated repayment and weekly fee are automatically withdrawn from your business bank account, which may be problematic if you're still waiting on an invoice payment and cash is tight. [See Related Story: Fundbox Review: Best Factoring Service for Very Small Businesses]

Factoring may or may not be the right financing option for your business. However, if your day-to-day operations are suffering due to large outstanding invoices, you don't qualify for bank loans or lines of credit, or you need cash quickly and don't have time to apply for traditional financing, you should consider factoring.

The potential downside to factoring is that the fees can add up quickly, and it may end up being more expensive than a loan or other types of financing. You need to consider whether immediate access to working capital is worth the higher price, and whether factoring will help your business expand or recover while achieving specific long-term goals or if it will exacerbate existing issues.

Factoring is most beneficial to those with a reliable client base and a net 30 or net 60 payment structure. Factoring isn't 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.

Once you've determined that factoring is the right financing option for your business, it's time to look for the service provider that will be 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 your business community to provide references to help you find 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.

"Overall, factoring is a simple finance transaction," Steklov continued. "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 Business News Daily staff members.

Editor's Note: Looking for 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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Lori Fairbanks

Lori Fairbanks has years of experience writing and editing for both print and online publications. After graduating from Brigham Young University with a Bachelor of Arts in English, she worked as an editor for Creating Keepsakes magazine and then as a freelance writer and editor for a variety of companies, including marketing firms and a medical university. She joined Purch in 2014 as a senior writer for Top Ten Reviews and now writes for Business.com and Business News Daily.