Invoice Factoring

Businesses use invoice factoring to get invoices paid faster through a third-party “factor.”

Invoice factoring often entails steep, hidden fees and restrictive contracts, whereas alternatives — such as early payment discounts — can deliver a simpler and more cost-effective solution for suppliers in need of working capital.

What is invoice factoring?

It’s the practice of advancing cash on unpaid invoices using a third-party financing company known as a “factor.” Used by suppliers to get outstanding invoices paid faster, invoice factoring can increase their cash flow when buyers would otherwise wait the full term to make payments. Invoice factoring typically operates in the following way:

1. A supplier partners with a factor.
2. The factor purchases the supplier’s outstanding invoice for a portion of the invoice total (typically 70% to 90%).
3. The factor collects the full invoice payment directly from the buyer according to the original payment term.
4. Once the payment is collected, the factor gives the supplier the remaining invoice amount minus factoring fees (invoice factoring rates range from around 1% to 5%, depending on how long it takes to collect payment).

Invoice factoring is often used by small to mid-sized suppliers that struggle to maintain cash flow and don’t qualify for traditional working capital solutions such as business loans. Factors offer these businesses faster payments for a cash flow boost and usually consider buyers’ credit histories more than the supplier’s.

Invoice factoring vs. invoice discounting vs. reverse factoring

People frequently confuse invoice factoring with invoice discounting and reverse factoring. Here are some key differences:

• Invoice discounting excludes any third-party lenders. Instead, the supplier offers the buyer a small discount in exchange for early payment. If the discount offer is accepted, the buyer funds early payment directly to the supplier. Buyers and suppliers can implement early payment discounts through programs such as C2FO’s. These are often more cost-effective than both reverse factoring and invoice factoring while giving suppliers more flexibility and control over early payment terms.
• Reverse factoring, or supply chain financing (SCF), involves a third-party financing company. However, supply chain financing is initiated by the buyer, not the supplier: The buyer partners with a fintech company or a bank, which pays suppliers early in exchange for a discount. The buyer pays back the lender in full at the agreed term, and the lender profits from the discount.

Important considerations

Invoice factoring can help suppliers access the working capital needed to operate and grow. However, it comes with some significant disadvantages that businesses should consider before entering into a factoring agreement.

The first and perhaps most important consideration is cost. Invoice factoring companies have earned a reputation for complicated contracts containing hidden fees and confusing fee structures. For example, factors typically charge based on the length of time an invoice remains outstanding, and they have additional fees such as contract termination fees, monthly volume fees and buyer credit check fees. Businesses must be careful to read contracts thoroughly and understand the financial commitment before signing one.

Secondly, by factoring invoices, businesses relinquish some control over their buyer relationships. When a factoring company buys an invoice, it decides how and when to collect payment from the buyer. This can impact the trust and communication established between buyers and suppliers, especially if the factor uses robocalls or unfamiliar processes to collect payments.

Lastly, factoring companies often use inefficient processes. Its paperwork and outdated systems often leave suppliers waiting for payments anyway.

The disadvantages of this type of financing

• Hidden fees. Suppliers usually factor invoices to access working capital, but factoring fees can add up quickly.
• Misleading contracts. Many factors rely on confusing contracts that can make it hard for suppliers to understand fee structures or end the agreement.
• Jeopardized buyer trust. Suppliers no longer control the payment collection component of their buyer relationships.
• Outdated processes. Many factoring companies still use legacy systems and paperwork, which can delay payments longer than suppliers expect.

How it compares to C2FO’s Early Payment platform

Businesses that want to avoid the costs associated with invoice factoring may benefit more from an early payment program such as C2FO’s. Here’s how the two solutions stack up: