Commercial Factoring Introduction
If your company's outstanding invoices total an entire month's revenues or more, it can be difficult for your business to function while you wait for the money to come in. By using commercial factoring for your accounts receivable, you get the funds quickly, allowing you to concentrate on growing your business while a third party collects the owed money.
Commercial factoring transfers ownership of your accounts receivable to a factoring company, sometimes referred to as simply "the factor." The factor advances you most of the money owed on the invoices you provide to them. They then pay the remainder — minus a factoring fee — after your clients pays their invoices. You can use the funds to make payroll, invest in materials for an ongoing project, or satisfy high-interest debts.
Commercial Factoring can be helpful for many companies, regardless of business size or success. You can often factor more than you could borrow, provided you have valid invoices from reliable customers. By working with the right factoring company, you can relieve yourself of the hassles of collecting payment.
Use this BuyerZone Factoring Buyer's Guide to learn:
- How commercial factoring works
- The various pros and cons
- How to shop for the right provider
- What you can expect to pay for services
Interested in factoring your accounts receivable? We can provide you with free custom quotes from multiple factoring providers in your area.
The first step in the process is to familiarize yourself with the basics.
If you have a steady client base that pays their bills more slowly than you would like, factoring can provide working capital based on your floating accounts receivable. It's particularly useful for startups or companies without much collateral for securing a traditional loan.
How it works
To work with a factor, you start by handing over copies of the accounts receivable that you want funded. Depending on your business and the terms of your agreement, the factor will advance you 70% to 90% of the total invoice value, usually by directly wiring it to your bank account. You can typically get an advance against your invoices within two to five days. If the factor accepts electronic invoices, you may get funded within 24 hours.
Before accepting the invoices, the factoring company will research your clients to make sure they are creditworthy and pay their invoices on time. The factor then takes the original invoices, looks them over for missing signatures or incorrect dates and makes the changes if there are discrepancies, and requests payment from the client. Once they validate the invoices, the factor will send a "notice of assignment" to your customers. The notice explains that all payments related to the outstanding invoices must now go directly to the factoring company.
After receiving payment from your customers, the factor wires you the remaining balance of the invoice, minus an agreed-upon factoring fee (or "discount rate") ranging from 1% to 5%. If you need a larger percentage of the total in advance, a factor may provide up to 90% of the invoice value upfront in exchange for a higher discount rate.
Most factors provide online invoicing systems that let you monitor the whole process in real time, from invoice submission to payment.
Next, it's beneficial to know the business benefits of factoring (and yes, there are a couple drawbacks to be aware of as well).
Factoring Services Uses & Benefits
Any business that invoices customers for payment can use factoring services. It is a significant source of financing for many companies that depend on fast billing turnaround, such as hardware stores, pharmacies, dry cleaners, florists, and wine and liquor distributors. Service industries such as temp agencies, security guard services, and trucking companies also use factoring services to meet payroll deadlines or simply improve cash flow as needed.
Factoring is also a valuable resource for businesses like garment companies and textile businesses that traditionally have a hard time securing loans. By factoring their accounts receivable, they can purchase raw materials or make other investments to grow their businesses.
The typical factoring service candidate has $5 million to $10 million in annual sales and $25,000 to $100,000 in accounts receivable every 30 to 60 days. But most factors will work with any company meeting a monthly minimum of $5,000 to $10,000 in invoices.
Businesses with less than $5,000 in accounts receivable may find a factor willing to work with them, but are likely to have to pay more for their services. You may want to consider a small business loan or low-interest credit card if you have less than $5,000 in monthly invoice value.
Benefits of factoring
- Simpler administration. Factoring features less paperwork than loans and no credit or reference checks of your business.
- Potentially more available cash. The amount you can factor is based on the total value of invoices, not by collateral or credit history.
- Easier to get funded. Factoring services are more concerned with your clients' credit history than your company's. Also, factoring services is a great option for startups that rely on quick availability of funds to keep business afloat.
Drawbacks of factoring
- More expensive. You typically pay more for use of the money for 30 days than you would for a short-term business loan.
- More time-sensitive. If you have invoices that have gone unpaid for 90 days or longer, a factor may not take on the risk, or could offer a much smaller advance on the invoices.
- Could harm business relationships. Dedicated clients may view factoring as intrusive since the factor will call and send letters to indicate their accounts were sold. Also, factors want their money right away and may require clients to pay sooner than they are used to.
As you move forward, it's time to figure out which type of factoring will best suit your business. Not to worry: there are only two options. But each has a number of unique aspects that make it suited to specific purposes.
Types of Factoring
There are two general types of factoring: recourse and non-recourse.
- Recourse factoring is the most common and most affordable. With recourse factoring, the factoring company will fund the invoices you submit, but will require a refund plus their fees for invoices that aren't paid within a specific period of time. You get a better rate with recourse factoring because you assume most of the risk.
- Non-recourse factoring frees your company of any responsibility for non-paying accounts. This is the more expensive option because the factor takes on more work and more risk. The factoring provider in a non-recourse situation will typically have more stringent policies for the invoices they will accept.
- There are also factors that will provide a mix of the two. These factors will assume the risk of your invoices but require you to swap in a replacement of equal or greater value for slow-paying or defaulted accounts.
Keep in mind that factoring companies are not collection agencies and won't chase your clients for payment. If there is a dispute or failure to pay, the factor will usually put the customer in touch with you before taking any action.
While factoring for most industries is essentially the same, the situation in the medical and construction industries is considerably more complex. Companies that concentrate on medical and construction factoring work exclusively in those industries. They have specific skill sets to deal with the complex billing issues involved. Because these industries are riskier to factor and because of the specialized skills involved, you can expect a smaller advance with a larger fee.
Depending on the type of invoice you factor, you may be billed differently. Most factoring covers standard invoices that require payment for time and materials or goods and services provided. This is known as non-progress billing.
Progress billing, on the other hand, refers to ongoing projects that get billed in monthly or quarterly increments. This helps a construction company, for example, make payroll or order supplies while finishing up a project. Since progress billing can require more work and maintenance for the factor, it's typically the costlier option.
Many businesses turn to factoring instead of business loans because it's easier to qualify and quicker to get funded. Factors typically charge fees based on 30-day increments, so businesses that need funding with flexible payment options over longer periods of time might benefit more from a business loan.
Another type of business financing is accounts receivable financing. This is similar to factoring in that your invoices are used as collateral for a short-term loan. However, unlike a factor, you are responsible for collecting from your clients. This could keep your discount rate lower, but requires more work on your end.
Now that you have a solid understanding of the process and how to choose the best factor suited to your business, it's almost time to talk with a provider. When you do, make sure you're only considering those that hold to your standard of business. Plus, there are a number of additional considerations to take into account as well.
Choosing a Factoring Provider
Whether you turn to a dedicated factoring company or a national bank with a factoring department, choosing the right factoring company to work with is important.
Look for a factoring company that understands your business and can provide the personal attention you need. The right provider will address any concerns you have and make sure the entire process is seamless.
What to look for in a factoring company
In addition to considering rates, there are many points to consider when choosing a factoring service.
Always speak with a potential factor before agreeing to work with one — either in person or by phone. Since the factor will have direct contact with your customers, you want to ensure the factor is courteous and professional in their communications. Ask to see sample letters or emails they send clients, or listen in on a phone call between the factor and a client.
Also, make sure the factoring company will handle most of the invoices you want factored. Most quality factoring companies boast a high rate of success obtaining payment from a business' clients. This is because they review the invoices carefully and only accept the ones they can validate. To ensure a factor can collect the majority of your invoices, provide a range of samples for them to review. Otherwise, you risk signing up with a factor who won't be able to provide the level of cash flow you want.
To iron out problems that inevitably arise, find out what level of customer service they offer to help resolve problems. Do they provide telephone support and in-person meetings, e-mail help and live chat, or a combination of services? Choose the factoring company that offers multiple ways to reliably address concerns or answers questions.
Consider the size and experience of the factoring company. Businesses that offer factoring among other services may be less expensive, but may not offer the same success rates and experience as a dedicated factoring company. Also, if a company has offered factoring services for many years, it's usually a strong indicator that they provide a reputable service to customers.
As with any major business purchase, make sure you ask for a list of references before you do business with them. It's preferable to have references in an industry like yours, but since factoring practices are similar in most businesses, you should be able to get valuable insight into the factor's qualifications. Make sure to ask such questions as:
- Were they able to quickly process your funding requests?
- Was the approval process simple? How long did it take?
- Was the company easily accessible through phone and email?
- Did the factor perform all of the responsibilities noted in the contract?
- How long did it take before you received funds?
- If you had a problem with your account, what did they do to resolve it?
- How did your clients react to working with the factor? Did the factor handle them appropriately?
If you're unsure which factoring company to choose, a broker works with several dedicated factors across several businesses of all sizes. A broker will assess different companies and match you with one that best fits for your business.
They also keep a close watch on factors that may charge exorbitant fees or regularly upset customers so they don't match you with them. You may pay a little extra on the initial fee, but it may be worth the investment if you need to find the best factoring solution quickly.
However, you don't need a broker to find the best factor. If you have finance experts in-house, they may know the best source for factoring services without having to pay a broker to do it for you. Also, with a little due diligence, you can find a quality factor on your own.
Factoring fees are based on percentages. But depending on certain business considerations specific to your company, the rate you pay for factoring services can actually vary quite extensively when working with large sums.
Factoring Prices & Contracts
The cost of factoring is based on the discount rate - how much the factor will take from your accounts receivable after they are paid in full. It can range from 1% to 5%, but is most commonly 3% to 5%.
The fee is largely determined by your:
- Volume: Multiple invoices with higher values can get you better discount rates than fewer invoices because it's less work for the factor.
- Customer base: If your invoices are for high-quality, credit-worthy clients, the factor may provide a more favorable rate.
- Industry risk: The discount rate could be higher based on the industry you work in. Factoring invoices from garment industries, for example, will require a higher rate than from manufacturing plants because it's riskier which makes it difficult to secure loans. Also, factoring for businesses in the medical and construction industries may only provide 70% up front with a discount rate closer to the high-end due to the higher risks associated with billing recovery.
- Client credit history: Unlike business loans, factoring puts more importance on your clients' credit status than on yours. And if your clients have a sketchy credit history, it may not disqualify you as a factoring candidate but it could increase your rate to cover the factor's added risk.
- Billing considerations: Progress billing usually requires a higher factor fee since it requires more upkeep and communication with vendors than non-progress billing. Non-recourse factoring may cost more since the factor is taking on considerably higher risk.
Pricing for factoring services is typically set in 30-day increments. You pay the agreed-upon discount rate to cover the first 30 days of the factor's service which starts immediately after the factor validates the invoices. You will also pay additional daily fees for every day the outstanding invoices are not paid during the initial 30-day period.
If your clients tend to pay their invoices quickly, you may want to take advantage of "block pricing." With block pricing, you pay a slightly higher discount rate but are charged less for bills that are paid in less than 30 days. With a typical increment of 10 days, for example, invoices that are paid in the first 10 days will only get charged one third of the 30-day discount rate. If your monthly invoices total hundreds of thousands of dollars, you may even qualify for daily increments for maximum savings.
The following demonstrates how much one can save on factoring services if the factor offers incremental pricing. In this example, the company wants to factor $200,000 in total invoices.
|Increment||Discount Rate||Days until client
|Total factor fee|
|Per 30 Days||3%||27||$6,000|
|Per 30 Days||3%||6||$6,000|
|Per 10 Days||3.10%||27||$6,200|
|Per 10 Days||3.10%||15||$4,133|
|Per 10 Days||3.10%||6||$2,067|
A factor may charge a one-time fee to get your account started. Set-up fees can run the gamut from $500 for a basic application fee to $2,000 to $3,000 for the application along with due diligence such as tax lien inquiries, credit report searches, and invoice validation. There may also be a one-time brokerage fee of 0.5% to 3% to pay a broker that referred the business. Make sure you get a detailed list of the fee schedule before you work with a particular seller.
Most factors will require you to sign a contract which acts as a security agreement. The contract outlines:
- Terms. This includes the amount you receive up front, the discount rate, and how often you will use the factor's services in the allotted time.
- Collateral. Factors consider your accounts receivable as your main source of collateral, but may also do a blanket lien against all of your company's assets.
- Default provisions. This covers fraud, non-payment, and various circumstances to ensure the factor gets paid. You will then have to satisfy the debt by paying the invoice out of pocket or providing a substitute invoice of equal or greater value.
Make sure to read the contract carefully to make sure there isn't anything that looks questionable. Are the advance rates and fees clearly spelled out? Do you see any hidden or ambiguous fees? Will you have to factor a certain number of invoices? Having a lawyer review the contract can be a good idea since this arrangement significantly affects your company's revenues.
Contract lengths may vary based on your needs. If you only need occasional factoring services, you can get a month-to-month agreement. If you will depend on frequent factoring services, a six-month or one-year contract will provide you with more leverage for negotiating a better discount rate.
Some factors may require a contract even for one-time factoring. Make sure the contract is an open-ended agreement. This will save you from paying duplicate set-up fees if you need to factor in the future.
Factoring Buying Tips
- Negotiate. Don't automatically accept the first rate a factor offers: negotiate. See if they can save you money with a lower discount rate or reductions of other fees. If not, see if they can offer you a larger advance so you can put more money to work for you.
- Skill vs. cost. Although price can greatly influence your decision, be careful not to put too much emphasis on price over skill and service. The money you save may not be worth it in the long run if you face long payment periods or unreliable customer service.
- Select specific invoices. You don't have to transfer all of your invoices over to the factor, so pick and choose which invoices you want funded. If you have a large invoice from a customer you know will remit payment right away, collect the funds yourself and skip the factor's fees.
- Advise your customers. Even though factoring companies notify your clients that payment should go to them, you may want to let your customers know ahead of time. Hearing directly from you will help avoid raising skepticism or concerns.
- Check industry credentials. See if the factor belongs to a national organization like the International Factoring Association (IFA). Non-profit groups like the IFA assist professionals in the industry by sharing information, training, and resources to better serve their customers.