When you launch a startup, there are always a huge number of things to organize and think about, from sales and marketing to administration, operations, and human resources. However, finance is one of the key areas which lots of new entrepreneurs can get stuck on, particularly when it comes to cash flow.
If you run a business that involves having most customers pay you on account, you may very quickly find that you struggle to get paid on time, and that your cash flow is negatively affected as a result. While there are numerous strategies you can implement to turn this around, such as running credit checks, sending out payment reminders, making payment processes quick and easy for customers, and reducing inventory levels, you may still find that you’re short on funds each month and never feel like you can get ahead.
If this is the case, it’s worthwhile considering a financing option such as utilizing a factoring company. These businesses provide invoice financing to clients who need to get paid sooner rather than later, and might just offer you the lifeline you’re after. Read on for the lowdown on this system and how it can benefit you today.
Invoice Factoring Explained
So, what exactly is invoice factoring? This type of financing is also known as “debt factoring” or “accounts receivable financing,” and is provided by specific factoring companies. These firms convert the outstanding invoices of a venture — one that either sells goods or services to other businesses (B2B) or to government agencies (B2G) — into cash. This means that, rather than waiting for 30-, 60-, or 90-day invoices to be paid, ventures can get cash that can be used straight away.
Factoring firms typically pay their clients in two separate installments once they have decided to purchase invoices. The first payment comes as an advance upfront. It is usually for around 80 percent of the value of the invoice. The second payment installation, the final 20 percent (less a factoring fee) is then transferred to a business once the original customer has paid their invoice.
When it comes to choosing which businesses to deal with, factoring companies obviously have to be reasonably picky. They decide to lend money to clients because they see due invoices as representing a promise that goods or services which have already been delivered to customers will be paid for by those same customers.
The criteria factoring firms use to choose the businesses they work with tend to vary a little from provider to provider, however they’ll usually be looking for firms with credit-worthy customers, and with no outstanding tax or legal issues to worry about. In addition, they’ll typically avoid advancing funds for invoices which don’t come due and payable for 90 days or more; and they will usually put in place a maximum advance value limit that they’ll provide.
The process involved in accounts receivable financing is pretty straight forward. If you are keen to have your invoices factored, you need to submit them to a chosen firm to see if they will deem the invoices eligible. The factoring company will then conduct due diligence on your customers to ensure they are a low credit risk and that payments will be made in a timely manner.
After that, if approved, you will need to sign a financing agreement that details various information, such as the specific invoice(s) involved, the clients who need to pay the invoices, and the maximum dollar value that can be advanced to start with.
Next, the factor will provide you with your initial advance, of around 80 percent of the value of the single or multiple invoices. (Note, though, that this advance can range, and is typically between 70 and 98 percent.) Factoring firms base this advance percentage on certain risk parameters that they use in their calculations. These can take in details such as the type of customers you have (e.g., small businesses, large corporations, or government agencies), the industry your venture is in, and the size of the particular transaction.
Your clients will often be sent out a “notice of assignment” from the factor too. This letter notifies customers that their invoices have been purchased, and that all future payments need to go to the new “owner,” rather than your business (it’s wise to give your clients a heads up). Once the invoices have been fully paid by your clients, the factor will pay you the remaining balance, less their fee. This final amount is known as the “reserve.”
There are numerous benefits to be had from using a factoring firm. For starters, the big plus is of course that you will free up some cash flow in the short term, and likely reduce your stress levels as a result. Working with a factor will make it more viable for you to keep extending net terms to your clients too, which will then help to boost customer loyalty and increase sales.
Other prime reasons to use a factoring company include:
- Taking advantage of finance that is often cheaper than if you were to organize a merchant cash advance or get a loan from a bank or other lender.
- The process tends to be easier and faster than other lending options since you don’t have to submit a huge amount of paperwork or have your personal credit score analyzed.
- Factoring is a flexible service that doesn’t lock you in. You can use a factor purely as a one-off if you’d like, or for some other short period of time, without having to commit.