To keep moving forward, your small business needs the fuel of working capital. Learning how to get working capital is important, but can prove a challenge for small business owners. You have a variety of funding sources to choose from, and it’s helpful to be aware of the pros and cons of each. Two popular options are invoice factoring and invoice financing. They sound similar and are often lumped together, but there are some key differences. Here’s a comparison of these different ways to use your receivables to access immediate cash.
With invoice factoring, you sell your accounts receivable to a third party, often called a “factor,” who pays you cash right away on a discounted value of those invoices. This method is relatively fast and easy, requiring little paperwork, and you’ll immediately receive something like 70 to 85 percent of the value of your outstanding invoices.
Since you are selling an asset (your own invoices), rather than applying for a loan, your own personal or business credit is less relevant than the creditworthiness of the businesses who owe you money. For this reason, small businesses with lower credit scores often rely on factoring as a source of quick funds.
Issues to Be Aware of with Factoring
When you sell your accounts to a factor, you’re also going to be handing over your customer relationships during the payment cycle. Instead, the invoice factoring company will collect payment from them directly. If one of your regular customers wants to discuss an alternative payment plan, you will not have the authority to offer them any choices.
This hand-off can create an impersonal atmosphere in which it can be hard to communicate how much you value the companies that do business with you. Also, if the factoring company believes a customer is unlikely to pay, it may prevent you from doing business with that customer in the future. You might have no say in the matter, depending on your factoring agreement.
Speaking of factoring agreements, you’ll want to read yours carefully before signing anything. Factoring fees can vary, and there are many different types of fees that you might run into, such as service fees, origination fees, collection fees, and more. Finally, many invoice factoring companies operate on long-term arrangements, so you need to be sure that this will remain your preferred style of handling receivables.
Invoice financing is a credit line based on collateral (your receivable invoices) instead of relying solely on your personal credit. In other words, your invoices constitute a tangible asset, so you can receive short-term loans because the lender knows you’ll be able to pay them back. This is different than a traditional small business loan. The lending decision is made on the strength of your assets, so no credit check is required to get started. Your financer will a look at your customers’ payment track record and assign you a credit limit based on your business history and performance. You can then borrow up to that credit limit, paying it back as your invoices are paid.
Different financing organizations offer different payment periods. With invoice financing from Fundbox, you can repay in 12 or 24 weeks, depending on what you choose. Your repayment period gives you the flexibility to choose the right payment cycle length for each of your customers, and you maintain your relationship with them. You will continue to collect invoices, as usual, so your customers will always know who to contact if they have a concern.
Issues to Be Aware of with Invoice Financing
To qualify for invoice financing, you typically need to have been in business for a while. Fundbox typically likes to see a track record of six months, but different financing companies may have different track record requirements.
You also need to do business at a certain scale. Fundbox businesses usually have at least $50,000 in annual revenue; invoice financing isn’t available to very small or brand new startups that lack a history of transactions on which to base credit decisions.
The Question of Fees
Fees will undoubtedly be a top consideration for you when choosing how to finance our immediate small business expenses. Both of these methods involve some fees, but invoice financing costs are typically lower and more predictable for two reasons.
First, invoice financing generally involves a more straightforward agreement with fewer fees.
Secondly, with factoring, you are paying the invoice factoring company to do more work for you because it is personally collecting invoices from your customers. Since invoice financing is technically a loan instead of a sale, you can usually lower your fees by paying off the balance earlier than the deadline.
If you’re like most small business owners, there are seasons when you need immediate access to cash. Your unpaid invoices are a valuable asset, and you can best use that asset if you understand all your options.
Contributor: Irene Malatesta, Content strategist at Fundbox, passionate about working with entrepreneurs and mission-driven businesses to bring their stories to life. Fundbox is dedicated to helping small businesses grow by democratizing access to credit.
The SmallBizRising Blog is designed to be an educational content hub pulling information, best practices and practical advice for the small business owner and features topics including accounting, marketing, technology and more. Be sure to subscribe to stay up to date with new content as it is posted. The blog was created by The Neat Company and receives contributed content from a group of contributing companies that provide technology, services and solutions to small businesses.