WHAT IS FACTORING?
It’s not always easy for a small business to do an equity capital raise or get approved for a bank loan in order to get the cash they need to grow, especially for startups and early-stage companies. When business owners don’t want to give up equity or aren’t able to obtain a traditional bank loan, what other financing options do they have?
In these situations, one option to consider is called Factoring.
Factoring is a financial transaction and a type of debtor finance. Basically, a business sells its account receivables (invoices) to a third party (often called a Factor) at a discount. The discount is the amount the factoring company charges for the money advanced for factored invoices. Typically, this is a small percentage (2% - 3%) of the face value of the invoice and may be structured to meet the borrower’s needs.
It’s common for a small business to offer customer payment terms of 30, 60, or even 90 days. This can cause cash flow problems for the business and make it difficult to meet payroll, pay suppliers, vendors and other expenses. Factoring invoices gives the business immediate access to cash, and thus keeps them in good standing and helps them grow.
IS FACTORING A LOAN?
Technically, invoice factoring is not a loan, and wouldn’t be considered as debt on the business’s balance sheet. Rather, the business is selling its invoices at a discount to a factoring company in exchange for a lump sum of cash. The factoring company then owns the invoices and gets paid when it collects from the business’s clients or customers.
HOW DOES FACTORING WORK?
As previously stated, in general, the total cost of factoring is 2% - 3% of the account receivable (invoice), depending on how long it takes for the invoice to get paid. Keep in mind, an account receivable (invoice) represents work that’s already been completed or products that have already been delivered. Typically, a factoring company will advance somewhere between 80% - 90% of the face value of the invoice.
To keep it simple, let’s use round numbers. Let’s say a business wants to factor a $10,000 invoice for work that’s already been completed. On an 80% advance, 2% discount, the factoring company gives the business $8,000 today. In 30 days, the factoring company collects $10,000 from the end customer. The factoring company keeps $200 (2%) and gives the business the remaining $1,800. In the end, the business has netted $9,800 and the factoring company has collected their $200 (2%).
In my next article, I’ll explain HOW & WHEN factoring can help.
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