You’ve launched your own company with the hopes of realizing your entrepreneurial ambitions. But there will be many obstacles on your way to the top—namely cash flow. A staggering 82% of unsuccessful businesses fail because of poor cash flow management.
If you have slow paying customers, one option is invoice factoring. Invoice factoring enables you to get paid for outstanding invoices without having to wait for clients. You only pay a fee to the factoring company which in essence purchases your outstanding invoices.
Before you decide whether to use invoice factoring, it’s important to consider the pros and cons of the service.
The pros of invoice factoring
Getting paid promptly by clients seems to be a universal problem for business owners. According to the most recent data from the National Federation of Independent Business, 64% of small businesses have had invoices go unpaid for more than 60 days. For many businesses, waiting on money for that long can cause issues with the operation.
This is where invoice factoring can help. Here are the primary benefits of invoice factoring:
1. Immediate cash injection
You don’t have to wait for invoice payment. Invoice factoring companies immediately buy that invoice from you in exchange for the right to collect the invoice on your behalf. Understand that invoice financing functions differently, as you borrow money against your outstanding invoices and then pay back the lender once the client pays (the financing company doesn’t collect for you).
Now, there’s a fee for invoice factoring, but you do get cash right away. Also, the factoring company will give you an upfront amount, typically between 50-90% of the total value of the outstanding invoice. The rest is held as a reserve until the factoring company gets payment from the client. Once paid, you get the remaining 10-50% of the money, minus the fee for the service.
2. Simpler approval process
About 80% of small businesses that apply for a loan with a bank get rejected. For many companies, traditional forms of financing may not be a viable option, especially in the early stages. Invoice factoring is a much easier process. You don’t need impeccable credit and you don’t have to go through a lengthy application process. You just need to show proof of outstanding invoices.
Do note that the factoring company will make sure the client is likely to pay the invoice. So, approval for invoice factoring and the associated fees largely depend on your client’s business credit score. Once a client pays the factoring company and is on the books, you’ll be able to get your cash faster in the future for invoices with that client.
3. No collateral necessary
The nice thing about invoice factoring is that it requires less risk on your end. Because the invoice serves as a form of collateral, you don’t have to provide any additional collateral to get funding, which is usually a necessity for many small business loans.
4. Less time wasted overall
Time is money. With invoice factoring, you don’t have to worry about spending time getting customers to pay their bills. You toss that task to the factoring company.
This lets you spend more time on business strategy and growing your company. Using a factoring company equals less hassle and more productivity if you take full advantage of the service.
Cons of invoice factoring
Of course, there are some drawbacks to invoice factoring. And you absolutely should take these into account before you decide to apply with a factoring company:
1. Potentially high costs
Compared to traditional small business loans, invoice factoring can be more expensive. While a factoring rate of 1-3% may not seem like much, keep in mind that this is typically what is charged each week it takes your client to pay the invoice. If your client takes a while to pay the bill, you’re going to receive less of your money (which means using the service costs you more).
On top of all that, most factoring companies charge a processing fee, which drives up the cost of borrowing. This makes invoice factoring a potentially very expensive form of financing compared to other options.
2. Too much reliance on your clients
While it is nice that the approval process is easier for invoice factoring, your financing costs depend largely on your customers. This could be a good thing if your client has a great business credit score, because chances are the fee will be lower and your client will pay the bill quickly. On the other hand, this isn’t so good if your customer’s client score is low and/or that client has a tendency to pay invoices slowly.
In many ways, invoice factoring gives you less control when compared to other types of financing. Everything depends on your client’s creditworthiness and ability to pay an invoice on time.
3. Strain on business relationships
It’s quite possible that using an invoice factoring company to collect payment from a client could strain your relationship. First, your client may worry that you don’t trust them to pay bills in a timely manner. Second, your client may get the idea your business is weak financially and desperate for cash.
There is an easy way around these issues, though. Simply communicate your situation to your clients ahead of time. That keeps an honest dialogue open and helps establish trust.
Is invoice factoring right for you?
You want to take all the pros and cons into account before you make a decision. Here are some questions that can help you make a decision:
1. Is your opportunity cost sufficiently high? Will you miss out on a promising business opportunity because you’re waiting on payment from a client? If so, invoice factoring is a good choice.
2. Will invoice factoring significantly affect profitability? If you can bridge cash flow with savings, do that instead of using invoice factoring. If you need money now for working capital, then use invoice factoring to get a cash injection.
3. Are late payments a real issue for your company? Take a look at how long it’s taking customers to pay you. If it’s between two to three months, it may be wise to have a better way to bridge cash flow.
4. Are there ways to get customers to pay more quickly? René Lacerte, the founder and CEO of Bill.com, suggests using a cloud-based payment platform, offering incentives for early payments, and sending simple reminders to get clients to pay invoices promptly.
5. What other options do you have to bridge cash flow? Compare the cost of invoice factoring with other unsecured financing options that may be available to your business, like a business line of credit, merchant cash advance, and small business credit card.
Choosing the right invoice factoring company
If you’ve decided that invoice factoring is the right option for you, the next step is to find a factoring company.
There are a lot of companies out there and some are better than others. Analyze each company by asking the following questions:
- What percent of the invoice will be advanced?
- How much is the processing fee?
- What’s the fee per week for outstanding invoices?
- Is there a set period for paying the advance back, even if the client hasn’t paid?
- Who owns the debt?
Generally, you want to ask questions about how payment is collected from your customers. Because you don’t want to upset your clients. The good news is most invoice factoring companies don’t call up clients like debt collectors. Instead, they handle payments through their platform and you’re still the one in communication with the clients.
Make certain invoice factoring can get you where you need to go
Invoice factoring offers plenty of benefits to small business owners. Before you work with a factoring company, it’s important to make certain invoice factoring is your best option for bridging cash flow. So do your due diligence, explore all financing options, and crunch the numbers.
If you find that invoice factoring is your best choice, take the deal. Because solving cash flow problems will get you further on the path to fulfilling your entrepreneurial dreams. Not having enough cash? That will get you nowhere, fast.
Want more tips and advice from Fundera? Read "Five ways to market your business on a shoestring budget" today.