Invoice factoring is a financial arrangement where a small business sells its unpaid accounts receivable to a third-party company at a discount in exchange for immediate cash. Instead of waiting 30, 60, or 90 days for client payment, you receive most of the funds upfront. It is an effective cash flow tool for business-to-business companies, but it comes at a higher cost than traditional bank loans.
What is invoice factoring and how does it work?
Invoice factoring is the purchase of your unpaid invoices by a financial company, known as a factor. The factor advances you a percentage of the invoice value immediately and collects the full payment directly from your customer later.
The process follows four main steps:
- You deliver goods or services to a corporate or government client and issue an invoice with payment terms such as net-30 or net-60.
- You send the invoice to the factoring company. The factor verifies the invoice and advances you between 70% and 90% of the total value, usually within 24 to 48 hours.
- Your customer pays the factoring company directly according to the original payment terms.
- Once payment clears, the factor remits the remaining 10% to 30% back to you, minus their agreed fee.
Because payment relies on your client's willingness and ability to pay, factors evaluate the creditworthiness of your customers rather than your business credit score.
How much does invoice factoring cost?
Factoring costs depend primarily on the factor fee, also called a discount rate, which typically ranges between 1% and 5% per 30 days that an invoice remains unpaid. The effective annualized percentage rate (APR) often falls between 15% and 35%, depending on how fast your customers pay.
Several terms determine your total costs:
- Advance rate: The percentage of the invoice paid upfront (typically 80% to 90%).
- Factor rate / discount fee: The percentage of the total invoice value retained by the factor as their fee.
- UCC filing fee: A Uniform Commercial Code (UCC) filing is a public legal notice showing a lender has a security interest in your assets. Factors usually file a lien on your accounts receivable and charge a administrative fee for it.
- Reserve release: The remaining unpaid portion returned to you after the factor subtracts their fee.
Watch out for additional charges such as wire fees, credit check fees, or monthly minimum volume requirements. Before signing any contract or agreeing to terms with an invoice broker, you can verify brokers free at MCAFax.com/verify. MCAFax membership is free and helps you check the history of commercial funding sources.
What is the difference between recourse and non-recourse factoring?
Under recourse factoring, your business must repurchase any invoice that your customer fails to pay. Under non-recourse factoring, the factoring company absorbs the financial loss if your customer defaults due to credit failure or bankruptcy.
Non-recourse factoring sounds safer, but it carries higher fees and stricter qualifications. Furthermore, non-recourse protection rarely covers trade disputes. If a customer refuses to pay because they claim your product was defective or delivered late, the factor will still require you to reimburse them under either arrangement.
How does invoice factoring compare to other funding options?
Invoice factoring differs from traditional debt funding because you are selling an asset rather than taking on a loan. The table below compares invoice factoring against invoice discounting and a traditional business line of credit.
| Feature | Invoice Factoring | Invoice Discounting | Line of Credit |
|---|---|---|---|
| Primary Asset | Unpaid invoices | Unpaid invoices | Business revenue / collateral |
| Customer Contact | Factor collects payment directly | You collect payment privately | You collect payment directly |
| Approval Basis | Customer's credit strength | Your business financial health | Your business financial health |
| Relative Cost | Moderate to High | Moderate | Low to Moderate |
| UCC Lien Required | Yes (on receivables) | Yes (on receivables) | Yes (blanket or specific) |
Who is invoice factoring best for and when is it the wrong call?
Invoice factoring fits growing business-to-business (B2B) or business-to-government (B2G) companies with creditworthy clients that take 30 to 90 days to settle bills. Common industries include trucking, staffing, manufacturing, and commercial wholesale.
Factoring is the wrong call in these scenarios:
- Business-to-consumer (B2C) companies: Retail stores, restaurants, and direct-to-consumer services cannot use factoring because they do not issue net-30 invoices to corporate entities.
- Low profit margins: If your profit margin is 5% and the factor fee is 3%, factoring consumes most of your net profit.
- Slow-paying or bad-credit clients: If your clients consistently pay late or have poor credit history, factors will either charge high fees or reject the invoices entirely.