Waiting for invoices to get paid has long been a problem for small businesses. It’s estimated that $3.1 trillion in receivables is owed to U.S. firms on any given day. The problem gets even worse when companies pay late. Improving cash flow is especially important during the COVID-19 economy. This need for quick cash has led many small businesses to consider invoice factoring — selling accounts receivable to an invoice factoring company at a discount, plus a fee. Besides being expensive, invoice factoring comes with other risks to your business. Here’s how factoring works, and how a line of credit may be a better alternative.
Factoring is ancient history
Merchants and traders have been using a form of factoring since about 1754 B.C.E. (before the common era) in ancient Babylon, as spelled out in the Code of Hammurabi — a giant, black stone pillar detailing 282 rules governing commercial interactions, including establishing proper conduct, fines, and even eye-for-an-eye punishments. As early as 2000 years ago, Romans were believed to sell discounted promissory notes and hire third parties to settle their trade debts.
A closeup of the text of the Code of Hammurabi written in stone.
Invoice factoring, as a practice by name, began in England before the year 1400. Pilgrims brought it to America around 1620. English common law required that if a merchant wanted to sell invoices to a third-party for factoring, the debtor had to be notified. However, that requirement had fallen away by 1949, when most state governments in the U.S. had adopted rules so that merchants could make factoring arrangements without notifying the debtor.
Why businesses use factoring
The fact that factoring has been a common B2B practice for more than 3,700 years means that it has to be good for something, right? Basically, it’s a way for small businesses to get cash sooner instead of waiting around for their clients to pay on net terms, pay past due, or not at all. It also frees a company’s staff from the stress and workload of following up on collections. Understandably, however, this convenience comes at a price.
The hard and hidden costs
Invoice factoring brings several disadvantages to the businesses who use it. It can be much more expensive than other types of funding — taking a large chunk out of your profits — and it may even face you with other issues.
- The cost. The discount rate (or factor rate), depending on the factoring period, could range from 2% to 10% of the invoice. Plus, you may have to pay service fees, origination fees, credit check fees, or other fees added by the factoring company.
- The customer impression. Some factoring companies may issue a Notice of Assignment and verify your invoices with the debtor. If this happens, your customers may question the stability of your business, since turning to factoring is often a tell-tale sign of cash flow problems, so they may consider switching to your competitor.
- The contracts. Some factoring companies require long-term contracts, forcing you to sign over a majority of your invoices, rather than just filling a short-term cash crunch.
- The control over your business. To reduce their risk from customers who are likely to default, some factoring companies may even prevent you from working with specific accounts you had previously built relationships with.
A better way to maintain cash flow while waiting to get paid
Small businesses have more options than factoring to avoid the cash flow problems of delayed payments, even in situations where you can’t ask your customers to pay by credit card. A business line of credit from Fundbox can provide you with the financial breathing room to keep your operations going despite the peaks and valleys of irregular working capital that may come even when facing irregular payment on receivables. Best of all, this comes without your business having to offer a discount on early payment, sell your invoices at a loss, or sacrifice your control or reputation with your valuable customers.
This content is for informational purposes only. You should consult your own financial, legal, or accounting advisors before engaging in any transaction.