Complete Guide to Invoice Factoring

Waiting for customers to pay their outstanding invoices? You’re not alone. Invoice factoring can help.

Most invoices are set to payment terms of 30 to 90 days, meaning that from the day an invoice is sent to your customer, you’re unlikely to see that money for at least a month, if not longer. These long payment cycles put many small business owners in a constant cash crunch, making it hard to keep up with critical expenses like payroll, utilities or inventory. That likely prevents you from investing in growth opportunities or maintaining day-to-day operations that keep everything on track.

This guide will answer all of your questions about invoice factoring, helping you determine if it’s a good fit for your business.

What Is Invoice Factoring?

Invoice factoring is a form of alternative financing that involves selling your outstanding invoices to a third party (factoring company) in exchange for cash up front.

Because it’s a sale, not a loan, it doesn’t impact your credit like traditional bank financing. To prevent any confusion, the term “factoring” is often used interchangeably with “accounts receivable financing”. It allows small businesses to unlock the cash value of their invoices long before their customers pay their bills.

What Is a Factoring Company?

A factoring company (or “factor”) is a financing partner that purchases your invoices in exchange for cash.

Once you are approved to work with the factor, you can sell your outstanding receivables in order to boost working capital and avoid the delay of long payment terms. The factoring company verifies your invoices, funds up to 90% of the invoice face value, then collects on those invoices directly from your customers (via a notice of assignment). Once the factor collects from the end customer on the standard payment terms, they release the remainder of the invoice value to you, minus a small factoring fee – typically one to five percent.

How Does Invoice Factoring Work?

Factoring is a fairly simple and straight forward type of financing. Once you understand the process, you can determine if it makes sense for your business.

Who’s involved in a factoring transaction?

• The Seller (Your business)
• The Debtor (Your business’s customer)
• The Factor (The factoring company)

The five steps of invoice factoring:

1. The Seller provides a service or delivers a product, then sends an invoice to the Debtor.
2. The Seller submits that invoice to the Factoring Company for funding (for example, on Day 1)
3. The factoring company advances between 80-90% of the invoice value to the Seller, deposited into their business bank account (for example, on Day 2)
4. The Debtor mails their payment to the factoring company, which goes into a lockbox in the Seller’s name (for example, on Day 25)
5. The remaining 10-20% of the invoice value is released to the seller, minus a small factoring fee (for example, on Day 26)

Invoice Factoring Example

Factoring Advantages and Disadvantages

While there are many positives to invoice factoring, there are also downsides, depending on the nature of your small business and the factoring partner you choose to work with. Here, we’ll break down the the pros and cons so you can see the full picture.

Pros of factoring

• Immediate access to cash for your business
• Easier and faster approval than traditional bank lending
• No impact on your credit score

Cons of factoring

• Reduced profit margins for your business
• Hidden costs and fees from bad factoring companies

Read more about all of the advantages and disadvantages of factoring and the invoice factoring approval process.

How Do Companies Qualify for Invoice Factoring?

In order to qualify for factoring, your company will need to have the following items:

• Invoices to factor
• Creditworthy clients
• A completed factoring application – apply now
• An accounts receivable aging report
• A business bank account
• A tax ID number
• A form of personal identification

Are Factored Receivables Subject to Taxes?

So, invoice factoring presents many potential advantages for a company. But how does factoring fit into the tax system in the United States? This relationship is somewhat complex. For business owners, it can be difficult to identify whether factored receivables are subject to taxes payable to the federal government.

The IRS considers several factors in determining whether any factored receivables qualify as taxable. The purpose of this determination is to prevent firms from using invoice factoring to transfer income overseas or engage in tax avoidance or tax evasion regarding the use of invoicing.

Common Myths About Invoice Factoring

You may have heard some bad things about invoice factoring, potentially from someone who has used it before and had a bad experience. While there are certainly better factoring companies than others, and some that will try to take advantage of you, here are a few things about invoice factoring that aren’t true.

1. It’s only good for struggling businesses: Not true! Factoring can be a great cash flow solution for businesses of all sizes and stages of growth. For example, many large companies employ factoring simply to reduce debt.
2. It’s too expensive to be sustainable: While factoring is typically more expensive than traditional loans, most businesses that are a good fit for factoring have pricing power, meaning that they can incrementally increase their prices to compensate for factoring costs.
3. You can’t use factoring if you have bad credit: Wrong! Invoice factoring is often the best fit for businesses with bad credit. That’s because factoring companies really only care about the creditworthiness of your customers (because they’re the ones paying the invoices), not you as a business.
4. All factors are the same: Every factoring company is different. Some will try to take advantage of you with hidden fees, float, and other added costs that make factoring unsustainably expensive and unpredictable. Factors like altLINE don’t do that – as a regulated bank, we’re 100% transparent because we have to be, and we want to be.

Related: Myths and Misconceptions About Invoice Factoring

Independent Factoring Companies vs. Bank Factoring Companies

While the overall goal of invoice factoring is the same, choosing the right provider is critical. Know that there are two types of providers: those that are independent and those that are backed by a bank.

Independent Factoring Company

Independent factoring companies work with businesses who need to accelerate cash flow and may have been turned down by a bank. A business with creditworthy customers may be eligible to factor even if it can’t qualify for a loan.

However, an independent factor must borrow from a third party in order to fund your invoices. That can increase risk and costs for your business and can reduce efficiency. Plus, they aren’t FDIC-insured and as heavily regulated as bank factors, which makes it easier for independent factors to act in predatory manners. Much of any perceived negative stigma surrounding factoring is due to independent, unregulated actors taking advantage of borrowers.

Bank Factoring Company

A bank factor provides the same flexibility and benefits as an independent factor, but also offers additional advantages.

Easier transition to bank loan – A bank factor works with many businesses who are considered outside of the traditional credit box. Many of these businesses have been told “no” by a bank for a commercial loan, but they are still very strong candidates for working with a bank that offers factoring, or accounts receivable financing. Businesses that work with a bank owned factoring company may also have an easier time transitioning to a commercial loan at a later date.

Greater security – Banks are more secure and provide a sense of financial stability for the business. A business’s clients are very valuable relationships and a bank offers a level of comfort not found in independent alternative financing companies like BlueVine or Fundbox. Clients feel better about interacting with a bank than an unfamiliar or unknown business entity.

Competitive rates – In addition, since the bank has its own funds, it can offer the business very competitive rates. Unlike many independent factoring companies who work with multiple funding sources, a bank acts as a direct source of funds and eliminates the middleman.

Different Types of Invoice Factoring

Let’s look into each type of factoring so you know exactly what you’re looking for when you’re finding a factoring company to work with.

Recourse Factoring

If your customer fails to pay their invoice to the factor, you must pay back the recourse factoring company for the amount advanced. While this adds risk for you, recourse factors offer lower fees. For reference, altLINE is a recourse factor.

Non-Recourse Factoring

In non-recourse factoring, if your customer fails to pay their invoice to the factor, the factor assumes responsibility for the loss, not your business. This is lower risk for you, but generally comes with higher factoring fees.

Related: Difference Between Recourse and Non-Recourse Factoring

Spot Factoring

Spot factoring allows you to factor only one invoice. Let’s say you have one large outstanding invoice that you need paid now, a spot factor will fund that one invoice alone.

Whole Ledger Factoring

Whole ledger factoring means that the factoring company requires that you are factoring all of your invoices together. Some businesses don’t have payment delay issues across all customers, so this may not be preferable.

Disclosed Factoring

Disclosed factoring is where borrowers’ customers (the debtors) are aware of the factoring agreement in place. The customers receive a Notice of Assignment, informing them they are to pay the factoring company moving forward, rather than their vendor (the borrower).

Non-Notification Factoring

Non-notification factoring, also known as confidential invoice factoring or undisclosed factoring, occurs when borrowers’ customers (the debtors) are not aware of a factoring agreement in place. With non-notification factoring, the factor would refrain from sending a Notice of Assignment to the debtor. Instead, they communicate with debtors as though it is an extension of the borrowing business.

Industries Served by Factoring Companies

Generally, factoring works best for small B2B businesses and startups within the following industries:

• Staffing
• Manufacturing
• Consulting
• Food and Beverage
• Oil and Gas
• Transportation and Trucking
• Professional Services
• Apparel Companies
• Janitorial Services
• Wholesale and Distribution

Rates, Fees and Structures: How Much Does Factoring Cost?

When it comes to factoring rates and fees, the main drivers are:

• The size of your borrowing need
• The creditworthiness of your customers
• Invoice amount and the age of your receivables
• Whether all or only select invoices will be financed

Keep these in mind when you’re considering your factoring options. For more information about how each of these items impacts your total factoring cost, read our full article on understanding invoice factoring rates.

Hidden Fees and Float in the Factoring Agreement

Many independent factoring companies will try to charge you hidden fees buried deep inside your factoring agreement. Make sure you read your contract thoroughly and ask questions about anything that looks suspicious – it will save you time and money in the long run. The best invoice factoring companies will be 100% transparent with their customers, like altLINE. As a bank, we’re fully regulated and are both unable and unwilling to deceive our factoring customers. That said – we’re not the norm. Watch out for these kinds of hidden fees:

• Monthly minimum fees
• Maintenance fees
• Cancellation or Termination fees
• Float days and fees
• Due diligence fees

For more information about these specific fees and what they mean, read our full articles on understand invoice factoring agreements and invoice factoring float and other hidden fees explained.

How to Choose the Best Factoring Company

When you start browsing factoring companies (or if you’re looking to switch factoring companies), you’ll find there are tons of options. You’re obviously researching for the best factoring company, but how do you go about it?

Remember the difference between independent factors and bank factors. It’s best to prioritize finding a bank factor.

Factoring vs. Other Types of Small Business Lending

While there are many types of small business loans and alternative financing out there, not all are a fit for every business. Some require a certain credit score, or a minimum operating history. Others can be fast and easy, but expensive and predatory. What you’re looking for is a type of small business lending that fits your needs at a reasonable and manageable cost.

Invoice Factoring vs. Invoice Financing

The main difference between invoice factoring and invoice financing, also known as AR financing, lies in the underwriting criteria of the deal structures. While factoring offers greater flexibility, AR financing has more strictness around the credit profile. Consequently, AR financing typically offers preferred financing terms.

Another key difference between invoice factoring vs. invoice financing is who eventually collects on your invoices. With invoice financing, you retain control of collection. In invoice factoring, however, the factoring company assumes the role of collecting on the invoices they purchased. Other than the collection process (i.e. assignment), both forms of financing are nearly identical.

Both invoice factoring and accounts receivable financing benefit businesses by providing funds in advance of collection. When working capital is critical to your business operations – as it is for nearly everyone – both of these financing options quickly put money into the business. In addition, both offer professional credit services and receivables management. Many providers will offer both factoring and AR financing.

Invoice Factoring vs. Invoice Discounting

A common misconception is that invoice factoring and invoice discounting are the same thing. While they are similar, there are some key differences. Mainly, factoring is a transparent process and invoice discounting is more confidential. Read our full article on invoice discounting for more information.

Here are some of the other types of lending you may encounter, aside from factoring:

1. Traditional Line of Credit
2. Purchase Order Financing
3. SBA (Small Business Administration) Loans
4. Asset Based Loans
5. Equipment Financing
6. Inventory Financing
7. ACH Loans
8. Merchant Cash Advance

Find out more about alternative small business financing options and factoring vs. bank loans.

Is Invoice Factoring a Fit for Your Business to Improve Cash Flow?

Cash flow is the lifeblood of a business, and it can determine if the business grows or dies. If you’re considering invoice factoring, it probably means you’re looking for quick and reliable source of funding. Factoring can do just that: quickly turning your receivables into cash.

But what makes your business a good fit for invoice factoring? If you meet any or all of the characteristics below, it may be the right solution for your business.

• Do you have B2B customers?
• Do you offer payment terms between 30 and 90 days?
• Do you have fair or poor credit?
• Does your business have limited operating history?
• Do you have few or no assets to borrow against?

These are each legitimate reasons to consider invoice factoring.

Jim is the General Manager of altLINE by The Southern Bank. altLINE partners with lenders nationwide to provide invoice factoring and accounts receivable financing to their small and medium-sized business customers. altLINE is a direct bank lender and a division of The Southern Bank Company, a community bank originally founded in 1936.