What Is Invoice Factoring and How Is It Used?

LanternUpdated February 9, 2022

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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

With COVID-19 and quarantine, it’s a challenging time to manage a small business. Managing cash flow, payroll, and other expenses becomes difficult when business slows dramatically. Not to mention, you want to ensure that you and your staff are safe and healthy. Thankfully, there is assistance available through the Small Business Administration's (SBA) coronavirus relief options, which include SBA Express Bridge Loans and SBA Debt Relief. These helpful resources support your employees, offer funding to make equipment purchases, and assist small businesses in recovering from the economic impact of the COVID-19 pandemic.If you’re a small B2B business that frequently issues invoices to customers and vendors, you’ve probably encountered times when an invoice is late or goes unpaid. It can be frustrating and worrisome when income you expected is unavailable, leaving your business short on cash flow for necessary expenses. There are options like business lines of credit or short-term business loans, but you may also consider invoice factoring as a way to access cash quickly to meet immediate needs. If you have customers and vendors who pay invoices frequently, small business factoring is one way to leverage unpaid invoices without applying for an actual loan.While small business invoice factoring may not be useful for big, long-term expenses, understanding what they are and how they work could come in handy in the future.

How Does Invoice Factoring Work?

Invoice factoring occurs when you sell your unpaid invoices to a factoring company, or factoring receivables company, who then takes ownership of the invoices. Because you are selling your invoices, invoice factoring is technically not a business loan.Factoring companies will pay you a percentage of the invoice amount upfront, which reflects the advance rate. Advance rates are typically based on how risky the invoice factoring is for the factoring company. Some industries, such as the medical industry, may be seen as riskier, and thus offer lower advance rates from 60% to 80%. Other types of businesses such as staffing agencies, may command advance rates from 80% to 90%, and transportation often sees the highest.Once the factoring company receives full payment from your customers, they provide you with the remaining amount of the invoice, minus a factoring fee. When your customers pay, the factoring company collects payment on the invoices under specific terms they set. B2B businesses often use factoring as a way to supplement cash flow during seasonal slow-downs, economic instability, or when business costs suddenly change. While you may anticipate seasonality, sometimes unexpected events occur that leave you with few options to fund payroll and other working capital, in which case invoice factoring may help. To give you a better understanding of how invoice factoring services work, here’s a hypothetical example: Let’s say you own a clothing store that frequently sells large quantities of t-shirts to other organizations. Perhaps you sell $100,000 worth of t-shirts and invoice your customers with a due date in 60 days. However if you wait 60 days for repayment, your business could be left with a cash flow shortage, threatening the wellbeing of your operation.You could turn to an online business loan or a credit card to try and get cash quickly. But when you know your customers are reliable and pay invoices in a timely manner, invoice factoring may be an option to consider. You decide to sell the $100,000 invoice to a factoring company, and agree to pay a flat factoring fee (sometimes called factoring rate) of 5%. Within 24 hours, the factoring company provides you with 80% of the invoice amount. You now have $80,000 you can use to supplement cash flow and regular business operations.80% of $100,000 = $80,000Over the next few weeks, the invoice factoring company collects payments on the invoices you sold to them. Once they receive full repayment, the factoring company pays you for the remaining invoice amount ($20,000) minus the factoring fee of 5%.$20,000 - $5,000 (5% of $100,000) = $15,000 back to youKeep in mind, that this hypothetical is an example to illustrate how invoice factoring may work in a practical situation. Note that different invoice factoring services may offer various terms and conditions, including flat rates, variable fees, and advance rates, which can alter how much money you receive up-front or when the invoice is paid.

Recourse vs. Non-Recourse Factoring

You might be wondering, what happens if customers don’t pay their invoices? With recourse factoring, the business is liable for paying the factoring company for any invoices that are left unpaid. This type of invoice factoring is more common because it is less risky for the factoring companies.Non-recourse factoring is less common because it means that the factoring company is willing to take on most of the risk associated with unpaid invoices. Typically, non-recourse factoring is only an option under specific conditions, like if the business that owes the invoice files for bankruptcy. Since the invoice factoring company is assuming more risk with non-recourse factoring, they may tack on a higher factoring rate as well. Carefully consider whether the higher rate is worth the amount of cash advance and compare factoring companies to see what terms they may offer.

Invoice Factoring Companies

Curious about lenders who offer invoice factoring? This sampling of lenders came from the Google search query “Best invoice factoring company”:

Lender	Rates start at:	Minimum Time in Business	Credit Score Required	Loan Amount
altLINE	Fee is calculated based on how long the invoice was outstanding.	Newer companies may qualify. Financial strength of invoiced customers helps establish eligibility.	Borrowers with bad credit may qualify.	Up to 80 to 90% of face value of invoices.
Blue Vine	Factor rates starting at 0.25% per week with LIBOR rate applied	3 months	530 or higher	Up to $5 million
Lendio	Factor rates starting at 2%	Contact Lendio directly for information.	Borrowers with bad credit may qualify. Eligibility based more on credit of the companies with outstanding invoices.	Up to 90% of receivables.
Paragon Financial Group	Factor rates starting at 1.25% - 2% per 30 days	Startups and “fast growing companies” may qualify.	Borrowers with bad credit may qualify. Eligibility based on customers’ ability to pay outstanding invoices.	Up to 90% advanced on your invoices.

All information was accurate as of 1/7/21.

Invoice Factoring Rates and Fees

Invoice factoring companies generally make money by way of factoring rates and fees they charge. Typically, you will see invoice factoring structured with one of the following:

Flat rate/fee: You pay a fixed percentage of the invoice to the factoring company and the rate doesn’t typically change even if the customer pays the invoice late. Depending on the industry you work in, flat rates are usually less common than tiered or variable rates.

Tiered or variable rate/fee: A percentage of the invoice amount is regularly charged until the factoring company receives full repayment; the longer invoices go unpaid, the more you’ll owe in factoring fees. For example, a factoring company may charge a factoring fee of 1% every 10 days until the invoice is paid. In this example, if it takes your customers 60 days to repay, the factoring company would keep 6% of the invoice amount. Some factoring companies may increase the variable rate the longer repayment takes.

Factoring rates and fees can be affected by:

The industry your business is in
Your customers’ ability to pay their invoices
The number and sizes of the invoices you wish to factor
Your business’ stability and creditworthiness

Additional Fees

Some factoring companies may also charge additional fees, such as:

Application fees: Charge for processing your application and setting up the account
Invoice processing fees: Help cover costs for things like credit checks and record keeping
Service fees: Charged in intervals to covers costs related to maintaining a current account with your factoring company
ACH or bank wire fees: When funds are transferred between banks there may be fees which are passed on to you from the factoring company
Early termination: Some invoice factoring companies may charge a fee if you decide to cancel your contract before the termination date
Due diligence fees: Coverage for costs incurred whenever the factoring company needs to verify the creditworthiness of the customers paying the invoices

Invoice Factoring vs. Invoice Financing

While they sound very similar, invoice factoring and invoice financing are two different financial products. Invoice financing differs in that invoices are used as collateral to receive a cash advance, rather than being sold to a factoring company. You receive access to a percentage of the invoice amount either in the form of a line of credit or loan. Like other types of small business loans, interest is charged on the invoice amount you are lent. You and your business are still responsible for collecting payment from your customers, whereas with invoice factoring, the factoring company is responsible for collections. Invoice financing gives you control over invoices and collections process, which may be more favorable if you prefer to deal with your customers directly.

Pros and Cons of Small Business Invoice Factoring

Invoice factoring can be a useful tool for business owners in certain situations, but it’s important to weigh the pros and cons before making a decision to avoid unnecessary expenses or added stress for your business.

Pros of Invoice Factoring

No collateral: Invoice factoring is an unsecured type of financing, meaning you do not have to offer collateral, or a valuable asset, to be approved.
Maintain healthy cash flow: Receive immediate cash to cover unexpected expenses or working capital, and maintain healthy cash flow in between invoice payments.
May be an option for those with lower credit scores: If financing or a bad credit business loan is difficult to get elsewhere, invoice factoring may be an option because companies are focused more on the value of the invoices and the credit scores of the businesses that owe the invoice than on the credit score of the business that the invoice is owed to.
Outsource invoice collection: For some businesses, it may be helpful to pass the responsibility of collecting on invoices to a factoring company so they can focus on other responsibilities.
Spend on what you need: Unlike other small business loans (e.g. equipment financing), you aren’t restricted to spending the funds you receive on specific business expenses.

Cons of Invoice factoring

Factoring companies have control: After you sell invoices to a factoring company, they may end up collecting directly from your customers. It’s important that the company be reputable and ethical in their dealings with customers.
It’s typically expensive: With various fees and relatively high rates, invoice factoring can be costly—especially if customers delay payment.
Recourse if unpaid: Since there’s no guarantee that an invoice factoring company will be able to collect on unpaid invoices, they may expect you to pay for, or replace the invoice, possibly with additional fees.
Approval may depend on customers: Invoice factoring companies want to make sure they will receive payment on the invoices they purchased from you. If your customers have a less-than-perfect repayment history, you may have a more difficult time getting approved.

Alternatives to Invoice Factoring

Invoice factoring can be one option to consider that can help businesses maintain cash flow and address short-term business needs. But if you need long-term financing solutions, or simply want to learn about other options, here are a few alternatives worth checking out:

Inventory financing: Used to pay for products that will be sold at some time in the future. The inventory acts as collateral for the loan.

Equipment financing: Used for the purchase of machinery, vehicles, or other business-related equipment.

SBA loans: Backed by the U.S. Small Business Administration and offered by banks and approved SBA-approved lenders.

Personal loans: Unsecured personal loans are based on your personal credit history (not business credit) and depending on the lender, may be eligible for business expenses.

Commercial real estate loans: For the purchase of a real estate for business use such as an office space, warehouse, or storefront.

Business line of credit: Gives you access to a maximum amount of funding with interest only charged on unpaid balances. Business lines of credit are typically revolving credit that function similarly to a credit card.

Online business loans: Online lenders offer similar loan options as a traditional bank, but typically have a faster approval process and may offer more options for people with lower credit scores.

Merchant cash advance: Allows small businesses (“merchants”) to get a cash advance for business expenses in return for a portion of their future sales or receivables

Choosing the Right Financing for Your Business

Whether you need invoice factoring or another form financing, we’re here to help you find simple, effective solutions. In minutes, you can compare online business lenders who fit your business’ specific needs. By spending less time searching for funding, you can devote more time to helping your business grow.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

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About the Author

Lantern

Lantern is a product comparison site that makes it easy for individuals to shop for products and compare offers with top lenders. Lantern is owned and operated by SoFi Lending Corp., the digital personal finance company that has helped over one million people get their money right.

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