What Are the Risks of Factoring (And How to Reduce Them)?

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Last Updated on December 16, 2022

It is not uncommon for businesses to struggle with the net 30 – 60 day payment terms of clients. Obtaining a loan from banks is not easy and so, business owners often turn to invoice factoring. After all, they need funds to run their businesses. However, like every other financial decision, invoice factoring is not without risks. Despite these, invoice factoring also has advantages as well as disadvantages, but, this article will be detailing everything B2B businesses need to know about the risks of invoice factoring and how to reduce them.

But First, Why Do Businesses Use Invoice Factoring?

Funding invoices regularly helps businesses build consistent revenue. In invoice factoring, a business sells its invoices to a factoring company which then takes over the collections process for the invoices since they now own them. Companies use invoice factoring for many reasons ranging from supporting growth to paying operating expenses to increasing profits through consistent cash flow. It is an alternative financing solution for businesses that want to scale as funds are easily available for use as long as customers make regular payments.

Risks of Invoice Factoring

Any financing option comes with its own set of risks. Below is an overview of common concerns we hear about invoice factoring to help you better understand the potential risks associated with this funding option.

Loss of Control Over Invoice Payments

Working with a factoring company relegates control of certain financial aspects of a business to a third party. This is because involving the factoring company to pursue and collect invoices and deficit funds is a loss of privacy for both customers and business owners. This leads to the loss of control over the collections process and invoice payments.

While many business owners enjoy having one less item on their plates, some do not like this loss of control. This is why it is important to thoroughly research invoice factoring companies before selecting one to work with. You want to make sure the company is reputable and has good reviews from its existing clientele so that you can feel comfortable handing over the collections process.

Upsetting the Customer Relationship

Unlike invoice discounting, invoice factoring actively involves your customers, so they are fully aware of the transfer of the invoice rights and payment process. This process change can cause friction in the customer-business relationship.

Let’s face it, many of these customers did not sign up for a third-party influence in business relations, and finding out, later on, can upset this balance. That’s why altLINE has an account manager dedicated to the customer onboarding process, ensuring your customer relationship remains in good standing as you begin the factoring process.

Unpaid Invoices and Recourse

There are two types of invoice factoring: recourse and non-recourse factoring. Some business owners may see recourse factoring as a risk because under this type of agreement businesses are still required to chase the payments of unpaid invoices if their customers refuse to pay. Usually under this type of agreement, the business buys back the unpaid invoice if the factoring company cannot collect payment on it.

This risk of non-payment by customers is not typically an issue if your customers reliably make invoice payments. However, if you are worried about factoring with recourse, you can explore non-recourse factoring options that put the risk and responsibility of non-payment on the factor.

Lower Profit Margins

Invoice factoring fees are typically 1 – 3% of the total invoice value, and this is usually more expensive than other forms of financing. These higher fees can lead to a lower profit margin for businesses. For instance, if an invoice of $5,000 is sold with a 3% factoring fee, the business owner receives $4,850, resulting in a lower profit with the $150 loss.

Even though invoice factoring tends to be more expensive than more traditional forms of financing, it is easier to qualify for, which could make it a good fit for your business.

Long Contract Terms

Most factoring companies require long contract terms that might span over years and can prevent business owners from easily pulling out of the agreement. If you are looking for a short-term solution to improve cash flow for your small business, it may be difficult to cope with the long duration of a factoring agreement.

Minimum Factoring Requirements

Some factoring companies require clients to factor a certain number of invoices per month at a certain value for an agreement to be reached. This can be challenging for small business owners who are just starting or do not have a well-defined loyal client base yet. If you are concerned about having a minimum factoring requirement in your contract, you can try to negotiate it out prior to signing. These types of contract terms tend to be flexible and negotiable.

High-Interest Rates and Hidden Charges

In addition to factoring being a more expensive route than traditional bank loans, there’s also the risk of hidden charges and fees, resulting in this type of financing option being even more expensive. It’s important to research the company and its operations before committing to an agreement, and you will want to read through your factoring contract carefully prior to signing. Keep an eye out for additional charges in the contract, such as origination fees, monthly access fees, lockbox fees, and credit approvals. Many of these charges can be negotiated out of a factoring agreement prior to signing.

Client Restrictions

Working with a factoring company incorporates the factor into the day-to-day operations of a business, and as such, they can have influence over which client invoices are factored. Many factoring companies will not factor invoices for customers that are not creditworthy or reliable. However, if your customers consistently make on-time payments, this should not be an issue for your business.

Negative Perceptions/Stigma

Because invoice factoring is not a well-known financing option, there can be a stigma attached to business owners that regularly use factoring to improve cash flow. Some customers perceive them to be financially insecure and may not be willing to do business with them. On the other hand, some consider it a smart business decision as it is a source of financial stability. This is why it is important to only work with trustworthy factoring companies so that customers do not feel uncomfortable remitting payment to the factor.

How to Reduce the Risk of Invoice Factoring

To reduce the risks listed above, it is ideal to use a trustworthy and reliable factoring company so that you and your customers can feel secure in the factoring relationship. Independent factoring companies are largely unregulated, which can make the risks outlined in this article more worrisome. We recommend doing thorough research and vetting of your factoring company prior to signing a contract with them.

altLINE is a unique factoring company because it is a division of the Southern Bank Company. Working with a bank factoring company that’s FDIC insured and state regulated, ensures there’s maximum transparency between the factor and you.

To work with an invoice factoring company that has 84 years of experience serving customers, fill out this quote form. We would love to help you get started on an easy funding journey.