Before the days of Quickbooks, Xero, Harvest, or Excel there was invoice factoring. Invoice factoring has been around for thousands of years but because technology has changed so drastically (especially in the last twenty years) we think it’s a good idea to provide an updated definition. Whether you’re a business owner or a finance leader, understanding factoring intimately will give you another tool in your toolbox when you’re looking to improve your business’ cash flow. It would be dated to describe a phone as something that plugs into the wall and requires finger dexterity to work a rotary dial, we’re using this post to provide an updated answer to the question: “What is invoice factoring (in today’s business world).”
The basics have stayed the same
It’s not a loan. It’s not a line of credit. And there’s no debt with compound interest. Here’s a quick breakdown of the process.
- Your company sells a deal to a customer and sends out an invoice to be paid on net terms (30-60-90 days)
- You have expenses. Payroll, marketing, and other bills due sooner than 30 days
- So you sell your invoice to a factoring company and have the majority of it advanced to you in 24-48 hours
A factoring company won’t be offering the exact same amount that’s on the invoice. For example, your invoice may be for $50,000 and the factoring company “buys it” for $49,000. Think of it as any other sale, but instead of a product or service, you’re selling your accounts receivable (an outstanding invoice) to a factoring company in exchange for an agreed-upon amount of money. Why it’s good for you - The value here is about speed and being able to keep growing your business. You have access to immediate funds, even though it’s less than the full invoice amount. Why it’s good for the factoring company - The factoring company is earning the difference between what they pay you for your invoice and the full value of the invoice. Sticking with the $50,000 example, the factoring company is turning its $49,000 investment into $50,000. What about my customers? - You’re getting a growth partner, not a collection agency. It’s in the best interest of the factoring company to care for your customer and the relationship you have with them. Downside - The factoring company has to wait a few weeks to receive payment. There's a risk there, but that’s what the factoring company is getting paid for. The biggest difference new technology makes is in the speed of the approval & underwriting process. Let’s turn back the clock.
20 Years Ago...
You had to fax over your invoices & business financials and wait for the factoring company to fax something back. Hopefully, nobody missed anything. Sign a physical contract. Then fax that over. Honestly, the big high-tech advancement of that era was the fax machine. The whole process could have been derailed by a broken fax machine. Or something getting lost in the mail. Or the factoring company opening up a window and everything blowing out to the street.
60 Years Ago…
It was the early 1960s, the age of horse and buggy. We jest, but it was before fax machines became popular. Mail or physical conveyance took time. There wasn’t an easy way to export your financials from whatever platform you were using. You, the owner or financial lead at your organization, most likely had to walk a banker through your books. The times have changed, and quickly.
Back to today
All it takes is adding a modern factoring company to your Quickbooks as an accountant (or Xero or Netsuite) to do the underwriting. Or if you’re an app developer or Amazon seller, just giving a modern factor access to your App Store financials (or whatever digital delivery platform you use). Simple as that. In a matter of minutes, a modern factor is able to review the invoices you’re interested in factoring and send you back an offer. You get to review the offer to make sure it makes sense to your business, and once you sign the factor wires you the money. That’s why we’re able to turn things around as quickly as 24 hours. There’s nothing standing in the way of immediately reviewing your financials and providing you a fast review.
Invoice factoring? Why not just sell my invoices to a collections agency?
It’s worth taking a quick detour here to distinguish the difference between factoring and collections. Collections is when a business takes its long overdue invoices (often 90+ days) and sells them to an agency. You might have a $100,000 invoice and sell it for $20,000 (maybe even less)Why it’s good for you - Hey, $20,000 is better than $0… Why it’s good for the collections agency - If they can collect even $30,000 of the $100,000 it’s a profitable purchase for them. What about my customers? It is in the collection agency’s best interest to get as much money as possible out of an invoice you considered to be a lost cause. There are some collection agencies that believe in trying to be a little bit more wholesome about communications, but for the most part collecting is a cutthroat business. Think of it this way - Invoice factoring is for your best clients who have always paid on time, but they tend to pay at the very end of your negotiated net terms. Collections agencies are for unreliable clients who are unresponsive or, honestly, your relationship with them has come to an end. Payments from these clients cost more of your time to chase down than it’s worth, so collections may make sense. They’re the type of invoices that factoring companies may not even take on or would be charging a much higher fee associated with the risk of these less reliable clients.
What does a healthy partnership with a factoring company look like?
It should be all about speed and transparency. If you send a request through the factoring company’s website you should be just a couple steps away from having your finances reviewed, an agreement signed, and money in your bank account. Transparency builds trust and you should expect total transparency around the flow of funds, the amount you’ll receive in advance, and the amount the factoring company is taking out of the invoice for their expenses before sending the rest of the paid invoice along to you.