Factoring: What It Is and How to Choose a Provider

When considering using a factoring service it may seem like a formidable task but doesn’t have to be complicated. We usually find there are three things to consider when selecting one for your business: What type of factoring does your business need? How much of your outstanding invoices do you need funded and when do you need it? How much are you willing to pay?

The first step to choosing the right factoring service for your business is figuring out which type of factoring you actually need. For instance, do you need a factoring service that covers all of your outstanding invoices upfront, or will a partial payment good enough? Do you prefer to keep receiving payments from customers, or will you hand all collections over to the factoring company? And do you want to be held responsible to the factoring company if customers don’t pay? These are just some of the considerations we’ll cover below.

How factoring works

Factoring is an alternative method of financing that allows business owners to sell their invoices, or accounts receivable, to a third party, the “factor.” Factoring helps to fuel growth by providing the funds necessary to keep businesses going while waiting for customers to pay for outstanding invoices.

Typically, the factor pays you between 70 and 90 percent of your total invoice value (sometimes in as little as 24 hours). The company collects your customers’ payments and forwards the remainder to you, minus its service fee.

Before accepting your invoices, the factor will conduct due diligence to determine the creditworthiness of your customers and whether they will be capable of paying their invoices on time. This is an essential step, as the factor typically does not function as a collection agency. To qualify for most factoring services, your customers’ accounts have to be in good standing. Some factoring services also consider other qualifiers, such as your annual revenues and how long you have been in business.

After accepting your customers, the factor reviews all outstanding invoices and inspects them for accuracy and completeness. If everything is in order, the factor typically requests payment from your customers by sending them a notice of assignment. This informs the customer of the service you’re using and instructs them to send all future payments directly to the factor.

Once payment has been made, the factoring service transfers the remaining balance owed on that particular invoice to you.

Types of factoring

There are two main classifications of factoring services:

Recourse factoring: This is the most common, readily available and cost-effective type. In this setup, the factor funds your invoices but requires you to provide a refund on any invoices that remain unpaid past a certain amount of time. Since the business owner assumes the risk with recourse factoring, there is a wider range of competitive rates.

Non-recourse factoring: This type of factoring releases the entrepreneur from any liability for delinquent accounts. Since the factor is willing to take on substantially more responsibility and legwork, this type of factoring is more costly. The creditworthiness of the client roster will be more closely scrutinized in non-recourse factoring. No matter what path you choose for your business, the fundamentals are the same.

Those interested in factoring should begin with research. This includes determining whether factoring is right for the business, and if so, which service provider is the best fit. The potential downside to factoring is that the service fees may add up over time, and end up being more expensive than lending. However, the higher price may be worth it for immediate access to working capital.

It’s important to view factoring as a financing strategy conducted over a period of time. Within this framework, realize that it can help you expand or recover while achieving specific long-term goals. Generally speaking, factoring is most beneficial to those with a reliable client base with a net 30 or net 60 payment structure. Factoring is not a solution for companies in dire financial situations. If your company has substantially more accounts payable than accounts receivable, factoring is probably not a good idea.