Business owners usually have lots of questions about invoice factoring, but there’s one that’s often overlooked: what is invoice factoring? Here’s the simple answer:
Invoice Factoring Definition
Invoice factoring is a financial tool where a business owner sells invoices to a factoring company. The business owner receives cash for the invoice amount, usually less fees, ahead of the payment terms. The business owner’s customer, who is responsible for paying the invoice, instead pays the invoice amount to the factoring company according to the original payment terms. (It’s important to note that this is different from invoice financing, where a factoring company still gives a business owner cash for their invoice, but the business owner pays back the invoice amount themselves, plus a fee.)
This simple definition doesn’t tell the whole story about factoring. To understand invoice factoring and why many businesses use it, it’s helpful to understand what it is not. There are a lot of misconceptions about factoring that have given it a bad reputation.
It’s not a loan; business owners don’t have to worry about paying the money back because their customer pays the factoring company. Most importantly, choosing to factor invoices doesn’t mean a business is struggling or can’t reliably serve its customers. Add to this perception that many traditional factoring companies charge hidden fees, don’t fund the full invoice amount, and take weeks to pay, and you can see why some people have a bad impression of factoring.
Thankfully, the truth couldn’t be more different: invoice factoring makes businesses more successful when they need to maintain their cash flow in the face of long invoice payment terms. (In fact, it often helps business owners stress less about their cash flow situation!) Let’s get more specific.
How is invoice factoring used?
The reason there’s a demand for factoring is because of long payment terms. In many industries, it’s not uncommon for standard payment terms to be anywhere from 30 to 120 days. Instead of business owners being paid right after they’ve delivered goods and/or services, they have to wait to receive payment.
This is a particularly difficult problem for small business owners who have large customers. They are excited to close a household-name customer for a large contract, but when they read the payment terms, they see that they won’t receive the money for months. This impacts their cash flow, not only making it difficult to run their business, but causing them anxiety. These small business owners need that money sooner rather than later to pay expenses, which can include:
- Making payroll
- Buying new equipment
- Paying their own suppliers
- Hiring staff
- Fulfilling large orders or projects
Those last two points are more common than you might think. With improved cash flow, many small businesses find themselves able to bid on projects that will require them to buy lots of materials or labor. Companies that had to turn down business due to a lack of cash can take on the extra volume. If this sounds like a stretch, just take a look at our customer stories. Run Veggie and Global Pipeline are two companies who are particularly direct examples of growing with invoice funding.
To understand how they were able to get paid quickly, it’s helpful to understand some basic information about the process.
How does invoice factoring work?
Every factoring company, business, and their customers are different, so these steps are generalized accordingly. This is more or less what you can expect when you factor an invoice.
- Business owner submits invoices for funding. Traditional invoice factoring companies often require a business to factor all their invoices for the duration of a contract. With many newer companies, you can choose which invoices you want to fund. (Full disclosure: FundThrough lets you pick which invoices to fund.)
- Factoring company does due diligence. Oftentimes this will include checking that a business is legally established, is up-to-date on taxes, and doesn’t have liens on their accounts receivable and/or the specific invoice. (Many factoring companies will find ways to work with businesses if they have these issues.) During this step, the factoring company will also verify that the invoice is real.
- The business’ customer is asked to sign an NOA. Having the customer owing the invoice sign a Notice of Assignment means they understand that the factoring company now owns the invoice so they can redirect payment. While a lot of business owners get concerned about their customer being involved, many large companies especially are used to this process.
- The business owner gets funded. The business owner receives cash in their bank account, less a fee. They can now have peace of mind that they have cash available to grow their business. (This is our favorite part!)
- The customer pays the factoring company according to the invoice terms. When the invoice is due, the customer pays the factoring company, and the process is complete.
If you started this article unsure about what invoice factoring is, you now have a comprehensive explanation. Beyond the dry definition, it’s important to know what it isn’t, why business owners use factoring, and how it works at a high level. A solid understanding of the whole picture and process makes you fully informed about this financial tool and how it can make a difference not only for a business itself, but in the life of the business owner.
We’ve found that when a business owner has steady cash flow, they’re freed from a huge hurdle keeping them from growth, and they no longer worry about having enough cash to keep their business running – even if they have enough money in accounts receivable. Having peace of mind about cash flow while being able to grow their business is why so many successful business owners take advantage of invoice factoring.