How Does Invoice Factoring Work?

If your small business runs on invoicing you may have already heard about invoice factoring. This financing method can help regularize your cash flow and it’s a quick answer when you have immediate cash concerns, but there are details of factoring of which you should be aware. Here’s a breakdown of how invoice factoring works.

You’ve Invoiced the Customer

In order to use invoice factoring, you have to actually work in invoices. It used to be that factoring was only for B2B businesses but now any service that invoices is eligible, so if you’re a physician or lawyer, factoring can work for you. A factoring service will review your open invoices, checking the credit score of your customers, and verifying that your business doesn’t have liens or other legal obligations that would take payment precedence.

Sell Your Invoices

When you find a lender you want to work with, they’ll do their due diligence and determine if they will buy all your open invoices or just a portion. The agreement will include the maximum you can borrow at one time and determine if you will factor invoices once or create an ongoing relationship that frees you from accounts receivable tasks.

The invoice factoring company will give you between 80% and 90% of the face value of the invoices.

Customers Pay the Factoring Service

You and the service will send out notices to your customers that their invoices have been assigned. This will give them all the information on how to send payment directly to the factoring service. Because the service is responsible for collecting your outstanding invoices it is imperative that you work with a company that will represent you in the best light. A company that harasses and harangues your customers could drive away future business.

You Receive a Final Payment

Depending on the agreement you will then receive another payment on the open invoices once they’ve been collected, but the factor will take their fees out of the proceeds. Expect to lose anywhere from 1% to 5% of the face value of your invoices. Your fees will depend on the volume of invoices you have, the creditworthiness of your customers and your line of business. More invoices and steady fields create lower fees. 

Because factors are private lenders it’s important that you shop around for the best deal and most professional services. Always review contracts with your attorney before you enter an agreement.