Understanding Factoring Agreements and Contracts

Last Updated November 20, 2024

As small businesses grow, financial obligations also expand, and that can create more of a burden on the company’s owners. Instead of diving back into their own pockets or looking to family and friends for more financing, many small business owners will turn to factoring agreements.

Factoring agreements and contracts bring in third-party financing with the small business’s current invoices. These agreements can seem complicated, but they can serve as a valuable tool for small businesses to utilize as they continue to grow.

Here are some of the most important things to know and consider when researching the ins and outs of factoring agreements.

What are Factoring Agreements?

A factoring contract is an agreement where a small business sells outstanding invoices to third parties — known as factors — in exchange for upfront cash. When these invoices, or accounts receivable, are paid by clients, the money will go to the factor, rather than the small business itself. Factors then make money from outstanding invoice payments and fees from the small business.

By entering an invoice factoring agreement, small businesses can get money upfront from unpaid invoices, providing them with liquid capital in the short term to maintain cash flow as the business grows.

Small businesses will also need to pay to cover the costs of factoring, account maintenance, and other legal fees. This is the benefit for factors in exchange for providing a credit line to the small business.

Small businesses do not need to put all of their accounts receivable into factoring agreements, but you must discuss those terms specifically with factors. Doing this will allow small businesses to select a certain amount based on the money needed to keep operating in the short-term.

Since entering factoring agreements cost additional fees paid to the factor, revenue will be lower in the long run for the small business. But the point of these agreements is to help maintain the current cash flow of the company.

It is important to understand all of the factoring agreement’s components when the contract is signed. Otherwise, hidden fees and costs can be detrimental to small businesses.

Related: Can You Have More Than One Factoring Company?

Common Fees and Terms in Factoring Agreements

There are a variety of fees small businesses can expect to pay when entering or exiting factoring agreements. It’s important to understand all of them and their ramifications if you’re considering a factoring provider for your company.

Origination Fee

When drawing up a factoring agreement, there is typically an upfront fee a small business will need to pay to the factor upon receipt of money. Factors will typically ask for a small percentage upfront, though the funds received from the factoring agreement should offset that fee.

Termination Fee

If a small business decides to end a factoring agreement, there is usually a termination fee paid to the factor, which is usually a percentage of the credit line from the factor.

The percentage varies based on the factor and the terms of the agreement, so it’s important to note what you agree to when entering the contract.

Monthly and Weekly Fees

Depending on your factoring agreements, your small business may be required to pay monthly or weekly maintenance fees on the contract. These fees vary from factor to factor, with various contracts offering different percentages over different periods.

It’s essential to weigh all of your offers and options when considering an agreement with different factors. Some factors might offer a smaller percentage taken weekly over a larger percentage taken monthly. That monthly fee could end up being lower, even with the higher rate.

Customer Limit

Factoring agreements have an overall credit line paid to the small business from a factor, but the factor won’t want to tie up the majority of that money in invoices from one customer. Only a certain percentage of the credit line can come from one customer’s invoice, so it’s important to know what that limit is when establishing the agreement.

Invoice Changes

Once a small business sells an outstanding invoice to a factor, the company is obligated to add a notice onto the customer’s bills stating that the invoices have been sold, and they must make their payments to the factor.

Any payments incorrectly made to the business instead of the factoring company must be turned over to the factor. According to altLINE account manager Mason Garner, this is one of the most common mistakes made during the factoring process, and procedures must be followed to revert the error.

“If your customer submits payment to you rather than altLINE, you should immediately forward all received payments on to altLINE and reach out to your customer to reiterate our Notice of Assignment (NOA),” Garner said. “An NOA is legally binding and states that all payments are to be sent to altLINE bank.”

Small businesses will also need to keep the factor up to date on schedules for any applicable accounts to ensure the related invoices and goods are delivered to customers.

Non-approved Accounts and Disputes

When a small business sells an invoice, the factor must approve of the customer tied to that invoice. This can mean the customer has to be deemed credit-worthy and doesn’t carry any outstanding risk.

Factors have the right, via contracts, to turn invoice accounts into non-approved accounts. If there are disputes between the small business, the factor, and the customer, most factoring agreements allow a certain amount of time for settlement before the account becomes non-approved.

Important Things to Consider with Factoring Agreements

Like any financial agreement, it’s important to understand various aspects of a factoring contract and how it could impact your small business now and in the future. Here are some key tips to consider regarding factoring agreements.

Read the Full Contract

Every decision and dollar for your small business matters, so it’s essential to understand every aspect of a factoring agreement from the beginning. Unexpected fees and other payments that you might have missed upon signing could cost you money in the long run.

Review the document with yourself, a partner, or even a lawyer to ensure you fully understand the contract so there won’t be any surprises down the line.

Factors Will Reflect as an Extension of Your Small Business

When you sell accounts receivables to a factor, the obligation for collecting payment on those invoices shifts over to the factor. This means that the factor will have direct contact with your clients involved in the factoring agreement.

How the factor handles those collections, and any issues will reflect directly on your small business, because that’s who the client agreed to buy from in the first place. You’ll want to have a clear understanding of how certain factors conduct their business and make sure they don’t alienate your clients.

Related: Accounts Receivables Financing

Understand Your Obligations

Factoring agreements typically included a monthly minimum, and financial penalties could follow if it’s not met. If you’re not comfortable about your small business meeting those needs each month, you should renegotiate the existing factoring agreement or consult another factor.

Final Thoughts

Factoring agreements can serve as a way to create a cash-flow influx for a small business in exchange for a third party taking on outstanding invoices. Clients from these accounts receivable will then pay the factor, rather than the small business.

Small businesses will need to pay fees over the course of a factoring agreement, so it’s vital to understand how those could impact the bottom line of a company.

Different factors offer various terms in their contracts, so taking the time to do the research on multiple lenders will pay off to make sure your small business is getting the most advantageous contract to help support the company’s growth and sustainability.