Lack of reliable cash flow is one of the biggest (as well as one of the most concerning) challenges that a new business owner can face. Unfortunately, it’s also among the most common problems facing many new business owners, especially those who own small to mid-sized businesses.
After all, most new businesses don’t have an abundance of excess cash for covering ongoing expenses like rent, utility bills, labor, and supply costs; instead, they rely on incoming cash from customers to cover those expenses.
The problem arises when customers take 30, 60, or even 90 days to pay up, as per their invoice agreement. While this many not be a problem for larger, more established businesses with a large financial cushion, the same can’t be said for most newer, smaller companies. Many business owners – especially novice ones – don’t have the luxury of waiting up to 90 days for their invoices to clear. They have real business expenses that need to be paid right now.
Fortunately, cash flow management problems are rarely a death sentence for budding businesses. Invoice factoring (also called accounts receivable financing) is an effective, flexible, low-risk funding solution for business owners who need to convert their outstanding invoices into quick, usable cash.
What is invoice factoring?
Invoice factoring is when a business sells their customer invoices that are due and payable to a third-party firm, called the “factor.” The factor pays the business quick cash in exchange for the right to collect payment from the business’s customer in the future, plus a fee.
In other words, the business gets to receive the cash they’re owed immediately, rather than waiting 30-90 days for the customer to pay up, and the factor gets to receive payment from the customer in the future, plus an agreed-upon fee from the business.
Here’s how it all works:
Step 1: You engage in a factor agreement During this step, you will need to ensure that you’re comfortable with all of the terms outlined in the agreement, and be wary of any possible red flags like hidden fees, long-term contracts, or monthly minimums.
Step 2: The factor arranges everything with your customers. Once the agreement is settled, all future payments from your customer will be sent directly to your factor (since you will have already received your payment from the factor long before your customer sends their payment).
Step 3: You make sales. Continue to generate business and earn sales from your customers, per usual.
Step 4: You provide goods and services to your customers. Similarly, you will continue to provide goods and services to your customers just as you always have.
Step 5: You create the invoices. Once your customer receives your goods or services in full, you will generate invoices that outline the dollar amount they owe you. You’ll need this in order to receive payment from your factor.
Step 6: Keep documentation. In addition to keeping track of your invoices, you’ll also need to keep track of any relevant supporting documentation, such as signed proof of delivery for goods purchased by your customer.
Step 7: The factor pays a % of the advance payment straight away. When you’re ready to receive your cash advance, you’ll need to submit your invoices and supporting documentation to your factor along with your request. They will then pay you an agreed-upon percentage of the face value of the invoice – typically 75-80%. The remaining percentage of the invoice (minus the fee) will be paid to you by the factor once your customer pays them.
Step 8: The factor pushes invoices to your customers. Depending on the conditions you agreed to, either you or your factor will contact your customers to remind them of their pending payment and the due date.
Step 9: The customers pay, with the money arriving at your factor. Since you’ve already received an advance payment from the factor, your customer’s invoice payment will be sent directly to the factor.
Step 10: The factor pays you the remainder of the advance request. Now that the invoice advance has been paid off by the customer, the factor will pay you the remaining balance of the invoice, minus the fee. Now that all payments have been received by all parties, the process is complete!
Benefits of invoice factoring
The key benefit of accounts receivable financing is that business owners don’t need to wait the standard 30-90 days to use the cash they’re owed – they can use it right now, as soon as they need it. In many cases, it only takes a day or two for the business to receive their cash from the factor, giving them peace of mind by knowing that they’ll always have the cash on hand to pay their employees and cover other expenses.
Many factors also offer expert support and guidance in collecting payments from slow-paying customers. This can reduce stress for all parties, as well as lead to improved customer relationships on your behalf.
Best of all, invoice factoring comes without all of the risks and complications of traditional bank loans, and doesn’t add any liability to your business’s balance sheet. It’s also less pricey than many other short-term funding options, like merchant cash advances.
Negatives of invoicing factoring
Invoice factoring is a cash flow management solution for business owners who:
- Need cash quickly
- Need to solve short term cash flow problems
- Don’t qualify for a traditional loan (since the factor judges your customer’s creditworthiness, not your own)
- But it also has negatives…
Invoice factoring may not be the right solution if you’re looking to receive extensive funding or long-term funding, or if you require a lengthy repayment period. It’s also worth noting that invoice factoring is not a viable solution for businesses who do not invoice their customers, such as B2C businesses.
Of course, it’s also cutting into your profit margins straight away, as you sacrifice greater revenues for the guarantee of cash flow. If you’re in a position where you’re overly reliant on invoice factoring, then you really need to look at the overall health and standing of your business.
In the end, choosing how to finance and fund your new business venture is not a decision that should be taken lightly.
Gage Price is the founder and president of MP Star Financial, a regional factor and asset-based lender located in the Cleveland Metropolitan area. Since his company began in 1995, Gage has advised countless businesses struggling with cash flow issues.
And don’t forget to support me as I rappel down the side of a 35-story building in downtown Chicago to raise money for minority and female entrepreneurs!