Invoice factoring provides an exceptional option for small businesses seeking rapid cash injections to boost their progress. It’s one of the best ways small businesses can rapidly increase their cash flow at minimal cost.
What Is Invoice Factoring?
Invoice factoring is a financial transaction through which a business sells unpaid invoices at a discount to a factoring company (also called a factor) for immediate cash.
Invoice factoring is one of two types of invoice financing. The other is invoice discounting.
The factor gives you an advance of a portion of the unpaid invoice and reserves the remaining amount until the customer pays the invoice. Once the customer pays their bill, the factor will release the reserved funds — minus the factoring fee — to your business.
The factoring fee is just one of the many fees you may be required to pay. Depending on the factoring company’s preference, it may consolidate all the related fees and present them as the total factoring fee or it may present each fee to you separately.
In the event your customer fails to pay their bill, you may need to repurchase the invoice from the factor.
Many variations of invoice factoring exist and they all change from one factor to the next. Some may require you to sign a long-term contract or sell a specific number of invoices each month, while others won’t.
Invoice Factoring: A Fixed-Cost Fee
Unlike many financing options that use an interest rate-based repayment system, invoice factoring has a fixed-cost fee for repayment. Many variables influence the factoring costs, but sometimes they also vary from one factor to another.
The most common factoring agreement is one between the seller and the buyer. It states that the seller (a business providing the invoices) will sell the invoices at a discounted rate to the buyer (a factoring company). The customer owing the invoice amount must then pay the bill to the factoring company.
Up until this stage, everything is quite easy to understand. The complexity creeps in with all the different variables factoring companies use to calculate their factoring fees.
The factor you deal with should draft a formal agreement containing all the terms and conditions. The invoice factoring cost can’t be considered an interest fee because you, as the seller, won’t make any fixed payments to the factor — either on a monthly or annual rate.
While the factoring fee will vary based on the invoice value, it’s a discount you offer the factor for an early payment. The fee doesn’t change based the duration the customer takes to settle their bill. It remains the same whether the customer pays in two days or two months.
In some cases, the fee may vary slightly based on the duration the bill remains outstanding. But, that’s not the standard procedure; it’s a term set by an individual factor. Regardless, the discount remains a one-time fee.
How a Factoring Company Charges Factoring Fees
The factoring fee — commonly known as a discount fee — is the amount you and the factor agree on for the invoice transactions.
If you agree to sell invoices to the factor at the discounted rate of 98 percent, for example, then the discount fee is 2 percent. As such, the factor would buy a $1,000 invoice for $980 and the discount fee would be $20.
The account debtor — the customer who owes the bill amount — should pay that $1,000 to the factoring company so the factor can make a $20 profit.
Factors That Influence Invoice Factoring Fees
Some factoring companies charge other fees in addition to the discount fee. These may include administrative fees, servicing fees, and collection fees, among others. The factor deducts these fees from the reserved invoice funds, but how does it decide on the amount to charge you?
Initially, you must make an agreement with the factor on a favorable discount rate. But, the factor will consider several variables before agreeing to a rate. Read on for more details about those key variables.
Choose a Factor In Your Industry
Some industries pose very high risks, and many general invoice factors will avoid working with businesses in such industries. The few factors willing to do so would have to charge higher discount rates.
The construction industry, for example, is considered an unstable, high-risk industry. If your business operates in this industry, you might want to find a factoring company that specializes in construction financing. Such a company likely would offer better rates than factors offering more general services.
The medical industry is another very high-risk industry so sellers in this field would fare better by finding a specialized factor.
Your Customer’s Creditworthiness and Stability
Invoice factoring relies on your customer’s ability to pay their bill. As such, their creditworthiness and stability influence the factoring costs. You’ll face lower discount rates for invoices owed by reliable and creditworthy customers.
Your Business’s Creditworthiness and Stability
In addition to your customer’s creditworthiness and stability, factors also will consider these criteria related to your business. If you have a good business credit history and have been in the business for a long time, factors will consider you reliable and award you lower rates.
Your Invoice Size and Volume
If your business offers the factor a higher-profit opportunity, then you likely will qualify for lower rates. But, a factor also bases its fees on the amount of work it must do.
If your business processes fewer, but heftier invoices, the factor will offer you lower rates because it doesn’t have to process many invoices.
There’s one exception to the rule. If you process a large volume of invoices, you likely will receive lower rates because your business offers the factor much higher profits compared to the quantity of work required.
Your Relationship With the Factor
The longer you work with a factor, the more likely you are to earn lower rates. As a factor grows more familiar with your business and customers, it must do less work to service your business. As such, it may be willing to lower your rates.
Additional Fees You May Encounter
Similar to providers of other financing products, invoice factors likely will charge extra fees to cover any costs they may incur during the course of your financial relationship.
Each factor and client varies, so your fees likely will vary as well. But, make sure to keep an eye on the additional fees you may encounter because they can impact your total costs.
Below you’ll find more details on some of the most common additional fees invoice factors charge.
Application and Start-Up Fees
Although common, not all factors charge an application and start-up fee. Those who do will charge you for the service they offer while evaluating your application and arranging a financial plan.
Some factors charge this fee up front while others ignore it until you sell them your first invoice.
Servicing fees — also known as administrative or maintenance fees — cover a comprehensive set of fees associated with your account maintenance and updating services. Factors normally charge servicing fees on a monthly basis, but some may use other intervals.
Invoice processing fees cover the costs a factor accrues while processing your invoices. Expenses stem from such services as maintaining records and conducting credit checks.
Monthly Minimum Fees
Some factors may ask for a minimum number of invoices each month. If you fail to meet that number, then the factor will charge you a monthly minimum fee to cover the difference.
ACH or Bank Wire Fees
If money transfers between you and your factor go through an automated clearing house (ACH) or bank wire, your factor may charge you a fee to cover those services.
Bank wires are faster, but generally more expensive so you’re more likely to incur bank wire fees than ACH fees. In some cases, however, factors charge for both.
Early Termination Fees
This type of fee is most common with a factor that requires you to sign a contract. Those contracts usually range from six to 18 months. You’ll incur an early termination fee if you cancel the contract before the end of its duration.