Last Updated on February 16, 2021 by Grey Idol
Finance companies generally offer two kinds of invoice factoring, recourse, and non-recourse factoring. In the case of non-recourse factoring, the factor (a third party who buys a company’s invoices for services rendered to give them the cash needed upfront) will assume the loss of unpaid invoices to end customer insolvency. This guide explores:
- Invoice factoring
- Non-recourse factoring and how it works
- The differences between recourse and non-recourse factoring
- The advantages and disadvantages of non-recourse factoring
Invoice Factoring: An Overview
Invoice factoring is a centuries-old form of financing for businesses. The modern style of factoring dates back to the 17th century in the U.S. and the 14th century in Europe, though ancient forms began as early as 4,000 years ago in Mesopotamia. It’s a method of business financing alternatives that are still widely implemented today, globally.
Unlike a loan or line of credit, invoice factoring utilizes your business’s existing outstanding invoices (i.e., money that you have already earned for goods or services). These invoices are “sold” to a third party factor who advances most of the invoice funds due (up to 80-90%) to you, the business.
Not only does the business that chooses to engage a factor receive cash advances on the invoices they sell, but they are also no longer responsible for directly pursuing payment from those invoices. The responsibility now lies with the factor.
That is why invoice factoring is a practical solution for small businesses for several reasons, including the need for cash flow, seeing the company through slow periods, or experiencing difficulty getting invoices paid efficiently.
Non-Recourse Factoring Explained
Full recourse factoring places all of the business’s liability that has engaged a factor for invoice factoring. Therefore, if a customer you have invoiced does not pay the invoice that the factor has bought from you, for any reason, then your company is responsible for paying the factor. Typically, the amount is what they gave as an advance and their lost fees.
In non-recourse factoring, the factor assumes the liability if your customer doesn’t pay the invoices you have sold them due to a qualified reason, which is most often customer insolvency. However, non-recourse factoring does not mean the business that sought the factor and received advances for the invoices takes no responsibility for unpaid invoices for any reason, at any time.
The qualified reason, such as customer insolvency, needs to occur during the factoring period outlined between the business and factor and often requires a form of legally declared insolvency (i.e., closure or bankruptcy).
While non-recourse factoring offers better protection for the business enlisting the aid of a factor, the factor still does not assume all of the risks for any given circumstance in perpetuity. The contract between a business and a factoring company should clearly outline the conditions and terms of full recourse or non-recourse factoring.
How Does Non-Recourse Factoring Work?
Suppose an official contracted agreement is entered between a business and factoring company that includes non-recourse factoring terms. In that case, the business receives protection against unpaid invoices due to the customers’ closure or bankruptcy.
However, suppose a customer is deemed to have good financial standing but cannot or will not pay the invoices bought by the factor with an advance to your business for other reasons. In that case, your business may still be held accountable.
The contract with the factoring company should outline what they will and will not cover, but here are some of the more common reasons for customers’ slow, delayed, or non-payments.
- Bankruptcy or closure
- Cancellation of work or product
- Issue or dispute with work or product
- Change in financial standing (undeclared)
Bankruptcy, closure, or forms of declared insolvency is usually the only reason fully covered by the factor in non-recourse factoring agreements. However, some terms may be more flexible in favor of the business, assuming more risk for the factor.
A customers’ issue with the work or product or cancelations is best resolved between the business and the customer, directly without involving the factor. Other reasons such as a customers’ change in financial standing that one has not legally declared may or may not be covered under the non-recourse factoring agreement.
If the problem remains unresolved and the invoice unpaid, at some point, legal action may be necessary.
Recourse vs. Non-Recourse Factoring
In the case of full recourse factoring, the business that contracts a factoring company assumes responsibility for the invoices paid to the factor which has given an advance to the business.
Non-recourse factoring offers some protection for the business at more risk to the factoring company, but the factor still needs to be paid for the customers’ invoices.
Outside of customer insolvency outlined in the contract, the business must directly resolve disputes, cancelations, or lack of funds from the clients.
In both recourse and non-recourse factoring, the factor can return the disputed, canceled, or unpaid invoices and contractually demand the return of the monies advanced, along with their fees.
However, factoring companies that enter an agreement with a business will often accept replacing the uncollected or disputed invoice with another valid invoice instead of a cash return.
Still, both kinds of invoice factoring come with advantages and disadvantages.
Advantages of Non-Recourse Factoring
Issues like customer insolvency from bankruptcy or closure are genuine, valid concerns due to the business’s unpredictability. Non-recourse factoring does offer peace of mind protection for invoices that are unpaid due to qualified reasons.
Because the factoring company will be assuming that risk on your behalf, many engaging in non-recourse factoring agreements will run commercial credit reports on services such as Experian, Dun & Bradstreet, and Equifax.
That helps them establish your current clients’ financial standing and better identify the customers who could potentially be a greater risk for slow or non-payment of invoices. Identifying such clients is useful for the factor and the business owner to avoid payment problems in the present and future.
Disadvantages Non-Recourse Factoring
Of course, the added protection from non-recourse factoring is not without its disadvantages. It is in the factoring company’s best interest to ensure the invoices they have purchased get paid in full and on time. To better achieve that, the factoring company may:
- Not approve all customers or invoices for factoring. Since they are assuming the risk if a customer doesn’t pay for a qualified reason, it is in the factor’s best interest to only approve factoring invoices they feel confident clients will pay.
- Charge a higher rate. They need to be able to cover themselves from unpaid invoices through trade credit insurance.
- Offer a lower credit limit for factoring lines. The factoring company’s trade credit insurance will seek to ensure their protection by placing limitations on factoring line size.
- Reduce or end a credit line. Because of the greater potential risk to the factor, non-recourse factoring lines are monitored with scrutiny and subject to reduction or end of credit as a preemptive measure.
Factoring is a centuries-to-millenniums old form of business financing that is as, if not more, relevant and beneficial to businesses today. It’s a practical tool for cash flow and growth.
Both full recourse and non-recourse types of invoice factoring have advantages and disadvantages to the business seeking to engage a factoring company. Non-recourse factoring offers an additional sense of protection against clients defaulting on invoices owed to the factor due to customer insolvency but may come with a higher price and limitations.