Invoice Factoring: What It Is and How It Works

Invoice factoring is a type of business financing that involves selling your unpaid invoices to a third party at a discount in exchange for an advance of cash. This type of funding allows B2B companies to access fast capital to manage cash flow issues or pay for short-term expenses.

Invoice factoring isn’t technically a small-business loan. Instead, you’re selling your outstanding invoices to a third party, usually a factoring company, at a discount. In exchange, the factoring company advances you part of your invoice amount, sometimes up to 90%. The company takes responsibility for collecting full repayment on your invoice. Once it receives that payment, it sends you the difference, minus the agreed-upon fees.

Factoring companies often charge fees at a flat rate, ranging from 1% to 5% of the invoice value per month. Extra fees may include service fees, monthly minimum fees and origination fees, among others.

Your factoring fee will depend on the invoice amount, your sales volume, your customer’s ability to repay a debt and whether your agreement is recourse or non-recourse.

If you have a recourse factoring agreement, you are responsible for the debt if your customer fails to repay their invoice. With non-recourse factoring, on the other hand, the factoring company accepts the loss if your customer doesn’t pay.

Non-recourse factoring agreements are less common, but will often have higher fees because of the additional risk the factoring company takes on.

Here’s a more detailed example of how invoice factoring works:

• You invoice your customer. You sell goods to another business, creating a $10,000 invoice.

• You sell your invoice to a factoring company. The factoring company agrees to buy your invoice and advance you 85% of the total value, or $8,500.

• Factoring company assumes responsibility for your invoice. The company collects repayment from your customer.

• The factoring company charges fees. The factoring company charges a 3% factor fee for every 30 days it takes your customer to pay the invoice. Your customer pays in 30 days, so your fee will be 3% of $10,000, or $300.

• The factoring company sends you the remaining balance, minus fees. Now that your customer has paid, the factoring company will send you the remaining 15% of the invoice amount, or $1,500, minus the $300 fee. You’ll receive a total of $1,200 back. This means at the end of the process, you’ve received $9,700 out of the total invoice amount of $10,000 — calculating to an approximate APR of 42.35%.

Invoice factoring may be confused with invoice financing, which is a similar type of business funding.

With invoice financing, however, you use your unpaid invoices as collateral to get a cash advance in the form of a loan or line of credit. You remain responsible for collecting payment on your invoices. Once your customer pays, you repay your lender the amount loaned, plus fees and interest.

Invoice financing may be better for businesses that want to keep control over their invoices. If you have a strong relationship with your customers and they repay their invoices on time, invoice financing may also be a more affordable alternative to invoice factoring.