Small businesses with less than $10 million in annual revenue have a hard time receiving loans from banks. The challenge is even greater if the business is only a few years old.
With a bank, everything feels safe. Secure. Most people are familiar with the traditional loan process so there’s less immediate uncertainty when considering this option.
With invoice factoring, especially if you’re learning about this alternative financing option for the first time, a different set of questions pop up: How does this work? Is it safe for my business? Is it worth it?
The question “Is invoice factoring worth it?” breaks into three different parts:
- Is it worth it in the short-term?
- Is it worth it in the long-term?
- Am I giving up too much?
Let’s address each one of these individually. We’ll show the pros and cons for each area leading up to an overall answer on whether or not invoice factoring is worth it.
Short term pros and cons
One downside of invoice factoring is receiving less money than what was invoiced. If you have invoiced one of your large credit-worthy customers $100,000, your best bet (if you already have good cash flow) is to wait for their full payment to be paid at the agreed-upon net terms.
What if your net terms are 30 days (or longer) and your cash flow isn’t where you need it to be right now. In the short-term, you have a marketing initiative that you really want to launch or you’re waiting to hire a few new engineers but you’re waiting until that $100,000 check comes in to support the initiative. Is it worth waiting the 30-60 days, putting the plans for business growth on hold to receive the full amount?
What would it look like to receive $80,000 the day you send the invoice and then another $17,000 once the customer pays in 30 days? You’re paying $3,000 in fees, but weigh that against what you were able to accomplish with the improved cash flow during those 30 days.
The pros of invoice factoring are similar to the pros of using a credit card in your business or personal life. Sometimes the growth plans for your business don’t directly align with the physical cash on hand in your checking account.
Too often, loans from the bank and credit cards get grouped together in one category and then there’s another category of ‘alternative finance’ way over there. What we recommend, instead, is to just group them all together, since the overarching question remains the same: Is it worth it to have the money now vs. wait for the cash to come in later?
In this way, invoice factoring doesn’t have to be seen as a Plan B or last resort but instead worthy of comparing side-by-side against bank loans and credit cards.
Short term – bottom line:
Using invoice factoring from reputable factoring companies, ones who keep low fees and provide top-level customer service is a good option for the short-term health of your business. You receive money faster than waiting on your customer for payment, you’re not paying interest, and the banks may not have been a viable option because of your annual revenue or your years in business.
Credit cards. Mortgages. Student loan debt. These things can build, in the case of credit card debt, or you could feel deep underwater in the case of a mortgage or a student loan without a way to surface. Depending on the amount of debt in relation to your revenue, it can take years to reach a $0 balance. Business debt, just like personal debt, has a real long-term impact.
Invoice factoring? A year from now, ten years from now, you’re not still paying off interest. There’s no debt involved with this option. Especially in the case of a spot factor (a factor that allows you to choose a specific invoice to factor) once the invoice you factored is paid by your customer, the transaction is complete.
The only downside might be at the end of the year, you’re looking at the total annual numbers and you say, “I factored $1 million worth of invoices, it kind of sucks not to have that $30,000 we paid to the factoring company.”
And I think that’s a natural reaction. It’s like when you look at the end of the year spreadsheet and say, “Wow, how much did we pay for Salesforce? How much for the LinkedIn licenses? How much did we pay in rent?” The full annual amount always stings a little bit more. But how much is “worth it” to increase your cash flow? How much would you discount your services if you could get paid in 0 days instead of on net 30, 60, or 90-day terms?
But, unlike a subscription service or rent, factoring fees don’t carry over into the next year. If your business is in a place where you don’t need to factor any new invoices, hey, that’s awesome. And if you do need help again, you know who to call (unless they did a bad job, then maybe reach out to a trusted loan broker to find a better partner).
Long term – bottom line
Factoring an invoice in 2019 doesn’t haunt you in 2029 or even 2020. This can be a better long-term option than on debt, which will show up on your credit report.
Giving up too much
This, of course, depends on what the specific invoice factoring company charges.
A general rule of thumb: 80% is a common percentage of the invoice to receive as an advance.
After that, you should be paying somewhere between 1%-4% of the invoice’s value per month in exchange for that advance. If the fees are higher than this, reach out to a few more options.
Also, make sure to understand the fees associated with factoring. Many invoice factoring companies love their fees as much as Comcast. It’s a much more straightforward business arrangement if you have a flat rate per week until an invoice is paid instead of something like late fees and a ballooning rate if your invoice is paid even 1 day past the original due date.
Giving up too much – bottom line
On the average net 30 invoice, you will receive 80% of the invoice as an advance, with about 3% of the invoice value going to the factoring company. Once the invoice is paid, about 17% (the remainder of the invoice value) is wired to you. Keep an eye out for fees that are significantly higher or more complex than this, and don’t be afraid to ask questions.