Last Updated on October 11, 2022
When you are a small business owner, your company will likely have a challenging time managing cash flow. It is also likely you’ll need to pay for goods and services before you have the cash to do so – things like payroll, for example. This is where invoice factoring can help, by turning your outstanding invoices into cash.
When you enter a relationship with a factoring company, you’ll sign an agreement. This agreement will outline all details of the financing process. It’s very important to read your agreement carefully and thoroughly – not all factoring companies are 100% truthful in their sales process. Again, read the fine print.
In this article, we’ll review what makes up a factoring agreement and how to protect your business against shady factoring providers.
Invoice Factoring and Factoring Companies
Invoice factoring is the practice of loaning money against a company’s future sales or receivables. It is often used by companies that have difficulty obtaining loans from traditional lending institutions due to having a low credit rating or insufficient collateral.
A factoring company purchases the right to a portion of your sales and then advances you the money before you receive payment from customers. You then have to repay the company the full amount, plus interest.
Factoring companies are strategic business partners who have experience working with small and medium-sized businesses. They help you with:
- Managing cash flow
- Accelerating receivables
- Reducing bad debt
- Increasing your overall profitability
Who Typically Uses Invoice Factoring?
Companies of all sizes use factoring. However, it is beneficial for small and start-up businesses that have difficulty obtaining traditional financing. Such companies are often referred to as “high-risk” or “bad credit” customers because they have difficulty obtaining financing on commercially reasonable terms.
But factoring companies are willing to work with these businesses because they are interested in the company’s accounts receivable.
The Primary Parts of a Factoring Agreement
A factoring agreement has many parts. Here are a few of the primary ones:
Sale and Purchase of Receivables
The first part of the agreement involves the sale of your receivables to the factoring company. You will need to provide the company with a list of your receivables and agree to sell them to the company for a specific price.
Rates and Fees
The factor will charge a fee for its services. This fee is typically a percentage of the invoiced amount and is paid when the invoice is. The factor may also charge a monthly fee.
The factor will typically advance you a percentage of the invoiced amount, less the fees. The remaining balance will be paid to you when your customer pays the invoice.
Notice of Assignment
You will need to notify your customer that the invoice has been assigned to the factor. Additionally, you will need to provide the factor with the contact information for your customer.
Term & Termination
The agreement will specify the contract term, which is typically one year but can be shorter or longer. Both parties have the option of terminating the agreement at any time.
Drawbacks of a Factoring Agreement
While a factoring agreement can be a helpful way to improve cash flow, there are also some drawbacks to consider. These include:
One of the most significant drawbacks to a factoring agreement is the cost. Fees can vary depending on the company, but they often depend on your credit rating or how much inventory you hold. On top of these fees, you’ll also have to pay interest on your borrowing funds.
In a factoring agreement, you give up some control over your accounts receivable process, which can be a significant disadvantage if you want to maintain tight control over your customer relationships.
For example, you may no longer be able to set your credit requirements or decide which customers to extend credit to. Instead, you may have to accept the factoring company’s terms and conditions.
Additionally, you’ll likely have less control over when payments are released to your customers.
Lack of Security for Your Business
Because a factoring company holds a lien on your receivables, they could potentially take legal action against you if they feel that you’re not upholding the terms of the agreement. This measure could cause severe disruptions to your business operations and lead to the loss of significant assets such as inventory or equipment.
So, What Does a Factoring Agreement Look Like?
Check out this link to a sample factoring agreement (provided by the SEC) to see what a one may actually look like.
When managed well, factoring can be a beneficial financing option for small businesses waiting on customers’ payments. However, like any other financing arrangement, it comes with a few drawbacks that you’ll need to be aware of before deciding to proceed.
Therefore, it’s essential to carefully read the terms and conditions of a factoring agreement before signing on the dotted line and entering into it. And, as always, consult with an experienced business attorney to ensure that the deal is in your best interests.
Grey was previously the Director of Marketing for altLINE by The Southern Bank. With 10 years’ experience in digital marketing, content creation and small business operations, he helped businesses find the information they needed to make informed decisions about invoice factoring and A/R financing.