The terms and conditions of an invoice factoring agreement can seem pretty overwhelming at first, especially since factoring contracts can be 20 to 30 pages long.
To be sure you’re negotiating the most favorable agreement from factoring companies, you need to understand the industry and legal jargon. This guide covers all the terms you need to know, why they matter, and the fees to be aware of before signing a factoring agreement.
Factoring Key Terms & Fees
What is a Factoring Agreement?
A factoring agreement is a contract in which a third party purchases a businesses’ accounts receivables, which in most cases are invoices but could also include other forms of receivables such as bills of exchange or promissory notes. Invoice factoring helps to provide working capital for manufacturing or production.
Compared to alternative financing options, invoice factoring offers very competitive rates. There are at least 50 factoring companies competing nationwide, which helps to keep the rates low.
Recourse & Non-Recourse Agreements
Your factoring agreement will either be recourse or non-recourse. It’s important to understand the distinction:
- Recourse factoring: Your business is responsible for any unpaid balances on an invoice. This is the most common type of factoring agreement.
- Non-recourse factoring: Your business will not be liable for the outstanding balance of an invoice in certain circumstances, particularly if a client declares bankruptcy. Instead, the factor assumes the risk which generally results in slightly higher factoring fees.
Related: Key Differences Between Recourse and Non-Recourse Factoring
Factoring Agreement Terms
It’s crucial to read and understand your entire factoring agreement before signing. Here are some important terms that you’ll come across:
Advance Rate
This rate is the percentage of the invoice that the factor will pay to your business once the invoice is sold. In most cases, you won’t receive the full amount of the invoice upfront. Rather, the advance rate usually falls between 70% and 95% of the invoice amount.
If your full invoice amount is $2,000, you would receive between $1,400 and $1,900 upfront. The advance rate you receive depends on many things, including the invoice value, your industry, and the creditworthiness of your clients.
Related: Invoice Factoring Rates, Factoring Fees & Costs
Factoring Fee
The factoring fee – also known as the discount rate – is the dollar value that the factoring company takes out of the payment of your invoice. Invoices for larger amounts usually have smaller factoring fees, but there are many other variables that impact the rate, including your sales volume and your customer’s creditworthiness. Generally, rates fall between 0.55% and 3.5%.
You can calculate a factoring fee by applying the factoring rate to the face value of the invoice. For example, a 2% rate on a $100,000 invoice would be purchased for $98,000.
If your business factors a $10,000 invoice every month for one year at a 2% rate, you would collect $120,000 in advanced rates, and the factoring company would collect $2,400 in factoring fees.
UCC-1 Lien
A UCC-1 lien is a legal form that a factor files to announce their security interest in your assets. This public notice informs other creditors that the factor has a claim on certain assets of your business. The UCC-1 filing typically covers your accounts receivable, but may include other assets.
It’s important to understand that a UCC-1 lien can affect your ability to secure other forms of financing while the factoring agreement is in place.
Minimum Volume Requirement
Some factoring agreements include minimum volume requirements. This means your business must factor a certain number of invoices or maintain a minimum dollar amount of factored invoices each month. For example, a factor might require you to factor at least $50,000 worth of invoices monthly.
Failing to meet these minimums could result in additional fees or termination of the agreement.
Contract Length
Factoring agreements can vary in duration, typically ranging from 6 months to 2 years. Many contracts include auto-renewal clauses, which automatically extend the agreement unless either party provides notice of termination.
For instance, a 1-year contract with an auto-renewal clause would automatically renew for another year unless you or the factor gives notice, usually 30 to 90 days before the contract end date.
Notification vs. Non-notification Factoring
In notification factoring, your customers are informed that their invoices have been sold to a factor. With non-notification factoring, customers are not informed, and you continue to collect payments which are then forwarded to the factor.
Non-notification factoring can help maintain your direct relationship with customers but may come with higher fees due to increased risk for the factor.
Holdback or Reserve Amount
The holdback, also known as the reserve amount, is the portion of the invoice that the factor retains until your customer pays. This typically ranges from 5% to 20% of the invoice value.
For example, if you factor a $10,000 invoice with a 10% holdback, you’d receive an advance of $9,000 (assuming a 100% advance rate), and the remaining $1,000 would be held in reserve. Once the customer pays, you receive the reserve minus the factoring fee.
Eligibility Criteria
Factors typically have specific criteria that invoices must meet to be eligible for factoring. Common criteria include:
- Invoice age (usually less than 90 days old)
- Customer creditworthiness
- Minimum invoice amount (e.g., $500 or $1,000)
- Clear documentation of goods or services provided
Understanding these criteria can help you determine which invoices to submit for factoring and avoid delays in funding.
Indemnification Clauses
Indemnification clauses protect the factor from certain losses that might occur during the factoring process. These clauses typically require your business to reimburse the factor for losses resulting from customer disputes, fraudulent invoices, or breaches of the factoring agreement.
For example, if a customer refuses to pay due to a dispute over the goods or services provided, you may be required to buy back the invoice from the factor.
Sales of Purchase and Receivables
Remember that in a factoring agreement, you sell accounts receivables to the factoring company. You’ll need to specify which accounts receivables you want to factor in the sales of purchase and receivables section of the contract. You may not want to sell all of your invoices.
Notice of Assignment (NOA)
In a factoring agreement, the factor holds claims to the payment from your customer. When you enter into a factoring agreement, your customer will receive a notice of assignment which alerts them that the right to collect payments has been passed to the factoring company.
The NOA is sent by the factor, and will usually require the customer to sign as an acknowledgment. Very few businesses are exempt from sending an NOA, as this document serves as legal protection for the factor.
Invoice Aging Report
A factor uses an invoice aging report to determine the amount of money that your customers owe on an invoice. Usually, this number falls on an assignment schedule of 30-day increments. For example, most assignment schedules follow 30, 60, and 90 day time periods.
Customer Limit
This is the maximum amount of funding that the factor will give you for a single customer. The factor sets a customer limit in order to minimize the risk of non-payment.
If the factor gave you a $50,000 credit line with a $10,000 customer limit, you could only use up to $10,000 for a single customer. The other $40,000 would have to be used across four or more other customers.
Customer limit affects concentration, which is a measurement of the risk involved in an account. If you have a single customer that is due to pay the full amount of the invoice, then the account is deemed to be a higher risk.
Fee Structure
Your factor will have either a variable-fee or a flat-fee structure. When the fee is variable, the fees will accrue for as long as an invoice is unpaid. For example, a factor might charge your business a 2% fee for the first 30 days, and another 1.5% for every additional 30 days that the invoice is unpaid.
With a flat fee structure, you may be charged a higher rate for the first 30 days, but the rate won’t increase. For instance, you may pay a 4% flat fee for the first 30 days of an unpaid invoice, and the same fee would apply for to next 30 days.
Reserve Account
The funds paid to the factor by your customer will go into escrow in a reserve account. This account allows the factor to track paid funds, outstanding funds, and the funds that are due back to you.
Schedule of Accounts
This is a report of all the invoices that you want to be factored. The schedule of accounts given to the factor before you sign the contract, and will allow the factor to determine the appropriate factoring fees.
Representations and Warranties
These are assurances given to the factor that your business is trustworthy. Before the factor takes you on as a client, they want to know that your business is solvent and legal.
Termination Provisions
If you or your factor decides to end the factoring agreement before the contract’s term is over, the termination provisions spell out any resulting payments or fees.
Factoring Agreement Fees
While many factors are transparent with their fees, many are not. In some cases, fees that a factor charges will not be specified in your agreement. To ensure that you’re not going to pay more than you bargained for, ask directly about the following fees:
Monthly Fees
Most factors charge monthly fees, which may also be called maintenance fees. These are flat fees that are charged monthly and may fall between 0.10% and 0.50% of the loan amount. These fees serve as reserves for the factor to maintain the loan.
Origination / Draw Fees
The origination fee – or draw fee – is a fixed fee that the factor will charge to cover the costs of researching your customers. This fee is usually charged per invoice and will come out of the advance. For example, if your advance is 85% of the invoice amount, but the origination fee is 2%, then your true advance is actually 83% of the invoice amount.
When calculating the cash that you will receive from a factor, you have to consider the origination/draw fees. Otherwise, you may risk gaps in your cash flow.
Early Cancellation Fees
Usually, fees will result from the early termination of a contract. These fees can either be a fixed rate, or a percentage of your credit. These fees should be specified in the termination provisions.
Credit Protection Fees
These fees typically apply in non-recourse factoring agreements and exist to protect the factor in some capacity from unpaid invoices. Credit protection fees are based on the determined risk from your customers.
Setup & Renewal Fee
The setup fee may also be called a ‘new account fee’. When you open an account, the factor may charge you for a fixed amount for the process of setting up your account. Similarly, the factor may charge you a fee when you renew your contract, even if the renewal is automatic.
Credit Check Fee
To ensure that the factor is not taking on too much risk, the factor will usually do a credit check on your customers. Sometimes, the cost of the credit check is passed on to you. Because many credit checks can be run over the course of a factoring contract, you should be sure to clarify who pays for the credit checks.
Minimum Volume Fee
This is also known as the minimum commission. The factor wants to be sure they’ll make money. Therefore, the factor will specify a minimum dollar amount that they will collect on a monthly, quarterly, semiannual, or annual basis. You will pay the minimum commission even if you don’t factor any invoices.
Lockbox Fee
It’s very common that your customers will pay an invoice through an online database, which is often called the “lockbox”. In some cases, the factor will charge you a fee for the customers’ use of the online payment portal. This is also known as an invoice upload fee.
Wire Fee
The factor will usually pass the cost of a wire transfer on to your business. Most wire transfers range from $15 to $30. However, you’ll only need to pay this when you need an instant transfer, as ACH transfers that take one day or more are usually free.
Final Word on Factoring Agreements
Knowing the true cost of a factoring agreement involves both decoding the legal jargon, and uncovering all of the fees upfront. Once you have the terms and rates straight, use our dollar cost calculator to help find the lowest rate.
That said, other variables impact which factoring company you should choose to work with. In general, the best factoring companies offer transparency allowing you to make an educated decision.
