So you’ve factored your invoices to improve your cash flow, but come to find out that one of your customers isn’t able to pay. Are you now liable for their outstanding debt?
The answer depends if your factoring contract is recourse or non-recourse.
What is Invoice Factoring?
Invoice factoring is where a company sells the value of outstanding invoices to a third-party company called a factor. The factor pays the company in two installments.
The first installment is a lump-sum advance paid to the company when the invoices are factored. The advance installment will be a large portion of the total value – usually 70% to 95%.
The factor assumes responsibility for collecting the invoice payments from customers. When customers pay invoices, the factor takes a small finance fee and then pays the remaining amount to the company. The second installment is often called a rebate.
Recourse vs Non-Recourse Factoring
To illustrate the difference between recourse and non-recourse factoring, let’s say that one of customers in the example above declared bankruptcy during the factoring period and cannot pay their invoice.
A recourse factoring agreement requires the company to buy back the invoice. Depending on the agreement, the factor could give 60 to 120 days to pay back the debt. If cash is unavailable, the company would need to provide a new invoice of equal or greater value as collateral.
With a non-recourse factoring agreement, the company does not have to pay back the factor for the defaulted invoice amount. Non-recourse factoring only offers default protection for the advance installment, not the rebate, so the company would still incur a partial loss.
Which Is Better?
Focus on getting the maximum advance with the lowest factoring rate (see our Dollar Cost Calculator). This will provide you with the most cash for the lowest cost.
If competing factor companies are offering the same rates, but one offers non-recourse, go for the extra protection.
Approximately 80% of all factoring companies offer recourse agreements. Recourse may have a lower factoring rate than non-recourse because of the reduced risk for the factor.
Non-recourse offers lower risk to the company, but it’s not entirely risk free. Although non-recourse offers more protection, there are many instances where you are still liable for non-payment. See more below about qualifying credit events.
Factors assess the credit of every invoice, and their rates will reflect the risk. If your company can break even on the advance rate, non-recourse could be a safe option since the rebate installments will be all profit.
Benefits of Invoice Factoring
Provides Working Capital
For a small fee, invoice factoring gives your business a cash advance on future payments. You can use this cash to pay expenses or invest in growth.
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.
Your Credit Score Doesn’t Matter (Much)
Your credit history is one of the least important factors for determining your eligibility for invoice factoring. If you have bad credit, it could mean a slight rate increase, but it will not make a huge difference.
Your customers’ credit and invoice value matter a lot more.
Helps You Avoid Credit Risk Clients
It is difficult for a small business accounting team to do thorough credit checks on every client. A factor can help provide guidance on prospective customers and their likelihood of default.
If they determine a client has bad credit, you can ask them to pay in advance to limit your exposure.
Downsides of Invoice Factoring
Your customers must have good commercial credit to qualify for invoice factoring.
It’s less of a concern for recourse agreements, but factor having faith your customers will pay is the foundation of every transaction.
Non-Recourse Credit Events
Most non-recourse agreements narrowly define insolvency as a declared bankruptcy during the factoring period. Some factoring companies have broader terms that cover default for any credit event.
There are no set industry standards, so pay attention to the details before you sign an agreement.
It’s worth mentioning that a non-recourse invoice factoring agreement does not offer protection against customer disputes or late payments. You would still be liable, for example, if your customer:
- Cancels an unfulfilled order
- Delays a payment while resolving a product quality dispute
- Is unhappy with the service you provided and decides not to pay
- Disputes the invoice and pays a lesser amount
Remember that factoring is about shortening the gap in receivables to improve cash flow on good debt. While non-recourse factoring provides some additional protection, it is not the same as accounts receivable insurance.
Invoice Factoring Costs
Average 30 Day Factoring Rates
|Industry||Advance Rate||Factoring Rate|
|B2B Business||70% to 85%||1% to 4.5%|
|Construction||70% to 80%||2.5% to 4%|
|Medical Billing||60% to 80%||2.5% to 4.5%|
|Staffing||85% to 93%||1% to 3.5%|
|Trucking||90% to 97%||1% to 5%|
Variable Rate or Flat Rate Pricing
Factoring companies often use a variable rate fee structure, especially in industries where customers often pay late or at irregular intervals.
Example variable rate fee structure:
|0.70%||First 10 days|
|1.15%||Next 15 days|
|2.65%||Following 30 days|
|0.85%||Each additional 10 days|
Variable rate pricing carries a slight conflict of interest: since the factoring company handles collections, if they are slow to collect, it will end up costing you more since their fee increases the longer an invoice remains unpaid.
You have a better chance of negotiating flat rate pricing if your customers usually pay on time. However, don’t get hung up trying to get the lowest rate.
It’s better to focus on the per dollar cost of factoring – that is how much each dollar you’re advanced costs you.
Per Dollar Cost of Factoring
Determining the per dollar cost is the best way to compare proposals from competing factors. This shows you the cost of each dollar you’re getting in the advance installment. To calculate the cost, you need the invoice value, advance rate, and factoring rate.
Per Dollar Cost Example
In the example below, the invoice value is $10,000.
“Proposal 1” has an advance rate of 70% with a 30 day average factoring rate of 3%.
Although “Proposal 2” has a higher factoring rate, it’s actually about 27% cheaper based on its per dollar cost.
The larger advance offsets the higher factoring rate. Given these options, “Proposal 2” is the obvious choice.
Click on the image above to view the spreadsheet. Fill in your invoice value, advance rate, and factoring rate (using a 30 day average) to compare the per dollar cost of each proposal.
Remember that factoring rates and advances can differ from one provider to another. It is definitely worth your time to shop around.
How Are Factoring Rates Determined?
Volume is the most important factor for a factor to determine a factoring rate.
Volume is a combination of the number of invoices and the total value.
2. Average Invoice Value
Clients with a high volume of large invoices command the lowest rates. It is much simpler for a factor to collect a single $50,000 invoice than twenty-five $2,000 invoices from different customers.
In both cases they are collecting $50,000, however, doing a credit check and follow up for a single customer is 25 times less work for the factor.
3. Customer Risk
Whereas volume makes the rate come down, customer risk makes it go up. The extent depends on how the customer and the transaction are rated by the factor.
If your customers have bad credit, expect higher fees.
If your industry is know for late payments, defaults, or otherwise difficult clients, expect to pay more.
Industries that require factors to have specialized knowledge to determine risk will also cause a rate increase.
|Low Risk Industries||High Risk Industries|
|Trucking||Medical / Healthcare|
|Consulting||Requiring Specialized Knowledge|
5. Your Track Record
Although your customers creditworthiness will have a greater impact on factoring rates than the health of your business, your track record still matters.
How long have you been in business? How stable are your sales? If you are a newer business, you’re likely to receive a slightly higher rate.
During the evaluation process, expect to get proposals in a day or two. Once you have an agreement in place, it may be possible to get same day funding on factored invoices, especially if your customer has already had an invoice serviced by your factor.
If you are just starting out, the entire process could take a week or two from proposal to funding.
This onetime fee could be as much as $2,000. Check with providers to find out what it covers and if it’s possible to waive based on invoice volume.
Invoice Upload Fee
Normally invoices you want to factor are sent digitally through an online portal or email. If you are reliant on paper records and need to mail invoices, factoring companies may charge a processing fee.
Credit Check Fee
Some factoring companies charge credit check fees for each new customer. If you have a lot of turnover, look for a factor that either has low or no credit check fees.
Minimum Volume Fee
Contract-based factoring rates are based primarily on volume. If you cannot maintain a minimum volume, expect to see a rate increase or be charged a fee.
Minimum volume may be based on the number of invoices factored or the total value.
The account where funds are held until customers pay invoices is called a lockbox. Some factoring companies charge a fee to maintain this account.
Most factoring companies prefer to use ACH payments. If you wire funds in or out of your account, they will probably charge you a fee.
Could also be called a servicing or administrative fee. This is used to cover costs for maintaining your account.
Early Termination Fee
Contracts for invoice factoring usually range from 6 to 18 months. If you dissolve your contract before the term is over you will need to pay a termination fee.
Alternatives to Invoice Factoring
There is no shortage of choices for business financing. To make the best choice, be sure to look at all your options.
|APR Range||10% to 84%||Maximum Loan Amount||$850,000|
|Minimum Credit Score||500|
Invoice financing is similar to factoring, but rather than selling the invoices you use them as collateral for a loan. Once you’ve collected your customers’ debts, you pay back your loan.
Although the rates are similar, you handle collections, which may represent an additional cost.
Business Credit Cards
|APR Range||17% to 34%||Maximum Loan Amount||$100,000|
|Minimum Credit Score||660|
If you have good credit, there are many advantages to financing business purchases with credit cards. The flexible payment terms are the main advantage, but by choosing the right card you can also earn bonus points and rewards on all purchases.
|APR Range||9% to 99%||Maximum Loan Amount||$250,000|
|Minimum Credit Score||550|
Short-term loans provide businesses with cash for immediate financing needs. They are usually used to help you get through a tough business cycle or to fund a new opportunity.
Invoice factoring is a better solution for long-term cash flow management.
|APR Range||8% to 24%||Maximum Loan Amount||$100,000|
|Minimum Credit Score||700||Origination Fee||1 to 8 points|
Installment loans are available for many types of business equipment purchases. Installment loans do not require specific collateral, so you will only be approved if you have good credit.
Normally lenders require that you’ve been in business for at least one year.
Hard Money Business Loans
|APR Range||8% to 15%||Maximum Loan Amount||$250,000|
|Minimum Credit Score||n/a||Origination Fee||2 to 8 points|
Hard money business loans are a high risk asset-based loan. These are normally used by companies that cannot qualify for other types of loans to finance their expansion. They could be a good option to fund an investment opportunity when a company has used up their lines of credit.
Private investors, mortgage companies, banks, and the SBA provide hard money business loans.
Final Thoughts on Recourse and Non-Recourse Factoring
There are times you might need the most cash possible – and that’s ok – even if it means not taking the lowest rate. And if you’re in a rush to get cash, keep in mind that recourse factoring is quicker to get set up because of less stringent credit checks.
Invoice factoring remains one of the most popular and affordable methods of business financing. As you review providers and proposals, pay attention to the advance rate and per dollar cost of each. If competing factor companies are offering similar dollar cost, but one offers non-recourse, go for the extra protection.
Now that you know how invoice factoring works, use a directory of factoring companies to find providers that can help you free up your cash flow.
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