Maintaining a healthy cash flow is one of the most difficult tasks for new entrepreneurs. It is far too easy to overspend, depriving the business of emergency cash, or underspend, failing to invest sufficiently in growth and placing the business in idle. Fortunately, there is a financial service that helps some business leaders achieve more stability in their cash flows: invoice factoring.
Factoring has existed for several hundred years, and many modern factoring companies have streamlined the service to give business leaders exactly what they need. Unfortunately, some factoring companies have complicated the process unnecessarily, making it difficult and confusing to attain the fast funding businesses need from factoring. This guide will help business leaders better understand factoring and its terms to ensure they end up with the right factoring service.
First, What Invoice Factoring Is
Perhaps due to a discrepancy of terms or else a lack of information on the service, business leaders are often confused by what factoring is and how it works. Simply enough, factoring is the sale of unpaid invoices to a third-party. Because a large accounts receivable tends to weigh on a business, factoring allows you to get your money faster with less hassle by paying a relatively small fee.
Contrary to popular belief, factoring is not a loan; unless stated in your factoring contract, you will never be forced to pay your factor (i.e. the factoring company that buys your invoices) the money they gave you to purchase your invoices. Also unlike a loan, there usually isn’t any interest associated with the purchase. Indeed, your business’s credit history doesn’t matter; because factors are earning their money from your clients, it is your clients’ ability to pay that factors consider when setting rates. However, there can be wild variation between contract terms and rates, which makes it incredibly important for you to know what you want and where to get it.
Next, Which Factoring Terms Are Best
Just like you would if you were applying for a loan, you should know what your business needs before you seek funding through factoring. For example, if your business follows a seasonal pattern, you likely need only short-term relief, whereas if you would prefer to avoid payment delay year-round, you need a longer-term contract. Before you approach any factors, you should know what terms are best for you; then, you will have lower chances of being trapped in a contract that doesn’t help your business.
Here are a few factoring term basics to help you determine what you need:
Advance rates and reserve accounts. This is the amount of money you will receive right away. Most factors retain a portion of the purchase price in a reserve account until your clients make their payments in full. You should know how much your advance rate is and how your factor handles your reserve account.
Recourse and non-recourse factoring. In recourse factoring, you assume the responsibility of payment should your clients fail to cough up. In non-recourse factoring, the factor takes on that risk. Most factoring relationships are recourse, but if you are willing to accept a lower advance rate and higher fees, you can achieve non-recourse options.
Factoring minimums and spot factoring. Most factors prefer to set minimums on the value of your sold invoices, and they tend to require specific time periods for payment. If you want more control over your factoring, you should find a company that allows you to pick and choose which clients’ invoices to factor, called spot factoring; otherwise, you can set parameters you are comfortable meeting and allow factors to take whichever invoices satisfy those limits.
Finally, How to Choose the Perfect Factor
You might hope that the perfect factor is whichever company offers the terms you desire at reasonable rates. However, because the factoring industry remains largely self-regulated, terms are often too good to be true, and unless you do proper research on your potential factor, you could easily end up paying too much for the wrong services. While you are shopping for factoring companies, you should look for the following qualities:
- Transparent. You should know with exactitude your factor’s rates, especially when it comes to fees and penalties.
- Secure. You should ask questions about your factor’s security to ensure your clients’ and your information is safe.
- Professional and personable. Your factor will be collecting from your clients, and if you expect your clients to return, you must have factor with impeccable customer service.
- Flexible. You may want to change your factoring terms in the future; your factor should be willing and able to adapt to your needs.
Factoring is an unendingly useful business service, but in business, it is more than possible to ruin your business through hasty or misguided action. By evaluating your needs and your factoring options, you should be able to find the perfect factor to resolve your cash flow problems.
