Finance and Lending
The 3 Biggest Disadvantages of Invoice Factoring Today
January 6, 2023 |
The C2FO Team
When you need quick cash for your business, invoice factoring may sound ideal, especially if you don’t qualify for traditional options — but it comes at a cost.
Optimizing cash flow is a consistent priority for most businesses. Whether you get a line of credit, leverage an early payment program or enter into an invoice factoring agreement, your business’s success often depends on securing working capital.
However, small and mid-sized businesses often face a significant gap in access to funding that is pivotal to their survival and growth. In fact, in a Small Business Credit Survey, 52% of respondents indicated their financing requests were unmet or the sum they received fell short of their needs.
This has created a void between the demand for traditional funding options, such as asset-based loans and bank lines of credit, and the funding actually supplied.
Capital is difficult for small and mid-sized businesses to access for several reasons. It isn’t because traditional lenders are against financing small businesses, but rather, because most have labor-intensive lending processes, with rigid qualification requirements that are unfavorable to small businesses or even completely out of reach.
As a result, many small and mid-sized businesses find themselves considering alternative financing options, such as invoice factoring, to bridge the gap. At first glance, invoice factoring may seem like an attractive and fast way to increase cash flow. However, there are also a number of issues to consider. In this post, we’ll cover key problems with invoice factoring and explain why early payment programs are a superior alternative to consider when you need to improve your cash flow.
What is invoice factoring?
Invoice factoring is a process in which a financing company, often called a “factor,” advances cash based on uncollected invoices. Factors typically advance 80% to 90% of invoice totals, so it can seem like a quick, easy solution to meet cash flow challenges. This allows factoring clients to build cash flow instead of waiting 60 days or longer for customer payments.
But the factoring industry is filled with inefficient processes and even predatory providers. Also, there are thousands of invoice factoring companies, so the sheer number of options can easily become overwhelming for business owners. Generally, though, there are two types of factors:
These brick-and-mortar providers usually focus on specific industries, such as the garment industry, temporary staffing, trucking and manufacturing. While traditional factors advertise fast payments, the amount of paperwork involved in transactions can often bog the payment process down.
These financial technology companies are typically industry-agnostic. They leverage technology to gain an edge against traditional factors. In many cases, fintech factors are trying to create an entirely new approach to factoring.
Three significant drawbacks of invoice factoring
You might be wondering: Is invoice factoring a good idea? For many business owners, invoice factoring has an unsavory reputation as “the payday lending of business financing.” That’s because long-term factoring contracts often come with confusing terms, sky-high factoring fees and the risk of interference in customer relationships.
It’s important to keep in mind that a traditional factoring company operates very differently from a bank. Banks follow specific steps in reviewing loan applications, including:
Examining business financial statements
Checking a credit report
Requesting and interviewing company referrals
Making a decision on an application
Signing a loan or factoring agreement
Factoring companies, however, typically work with small businesses and entrepreneurs in a faster, less structured way — but with the following major drawbacks.
Drawback #1: Confusing contracts
Factoring contracts can be very confusing, sometimes by design. As a factoring client, it’s crucial that you, the small business owner, understand the terms and jargon associated with a typical factoring contract. Here are some of the common terms:
Term requirement: Locks your company into factoring a certain amount of your invoices (often all of them) through the factoring company for six months, a year or even longer.
Monthly minimums: Requires your company to continue to submit invoices totaling a certain amount to the factor each month. If you fail to meet this monthly amount, you must pay this minimum fee.
Customer or concentration limit: Limits how much of your funding can come from a single customer’s invoices.
Additional reserve: Provides an additional cushion for the factor in case you use too much of your credit limit. Many factors use this reserve money without supporting data in cases where you draw more than 90% of your availability.
Factoring reserve: The amount of money the factoring company keeps after paying a cash advance on your invoice. If you get a 90% advance, the factor keeps 10%. Eventually — depending on the terms of the contract — you will get a portion of that 10% back, minus the amounts of uncollected invoices, as well as other fees and penalties, and the interest rate charged as part of the contract.
Guarantee: Requires you to personally guarantee the advances your company receives in the event that your customer doesn’t pay the invoices that you have assigned to the factoring company.
Ineligible invoices: The factoring company reserves the right to refuse any invoices you submit for any reason. Many factors exclude invoices from overseas customers, customers personally related to you and past-due accounts.
Recourse or non-recourse: These two types of factoring determine whether you or the factoring company are on the hook for nonpayment from your customers.
Collection days: The amount of time it takes the factor to apply payments it receives. Also called “float.”
Credit limit: How much in invoices (gross amount) the factor will purchase from you at any one time.
Invoice repurchase: When and under what circumstances you have to repurchase invoices sold to the factoring company.
Additional collateral support: Any additional collateral required for the factoring company to feel secure. This may include a lien on your house, office facility or other assets.
Fees and interest costs: When and how much you pay the factoring company for its services.
Drawback #2: Sky-high fees
Factoring fees aren’t easy to figure out. Typically, factoring companies charge a percentage of the invoice amount that you are factoring by the month, with some factoring companies charging a higher rate for larger amounts. Typically, the longer it takes your customer to pay, the higher the rate. Rates can range from 0.5% to 5% a month, or even more.
Factoring fees are usually structured in two ways:
Daily rate structure: The factoring fee increases every day a factored invoice is outstanding.
Tiered rate structure: The factoring fee increases every 10 to 30 days an invoice is outstanding.
There are also many additional fees that factors may potentially charge you. Here’s some to look out for when reviewing a factoring agreement:
Interest rate: In addition to the fees above, factoring companies generally charge an interest rate that masks the true cost to factor. Factoring companies will quote this rate as what you’re paying, such as “Prime + 1%.”
ACH fee: A transaction fee for transferring funds to you via ACH. The industry range is $5 to $50 per invoice.
Wire fee: A transaction fee for an immediate wire transfer. This can be as much as $200 or more.
Lockbox or service fee: Some factoring companies charge a monthly account maintenance fee, while others charge this fee to your customers to pay their invoices with the factor through an online portal.
Origination: An origination fee may be assessed when you open your account.
Draw fee: A fee paid when you access funds provided by the factor.
Online access fee: A fee charged to provide access to your account online.
Monthly minimum volume fee: A fee charged when you don’t meet your contracted monthly minimum of factored invoices.
Renewal fee: Typically a percentage of your overall line of credit that the factor charges when the line of credit renews.
Unused credit limit fee: A fee charged for not using a certain portion of your credit limit.
Overdue or collection fees: A fee for collecting late payments on customer invoices that you factored.
Credit check fees: The factor may run credit checks on your customers, charging you fees for those credit reports and their analysis.
Drawback #3: Interference in customer relationships
You and your customers have likely established a relationship and level of familiarity with your processes. For example, your customers probably understand how you send invoices and collect payments, which is good for your business and your customers.
However, generally speaking, when you enter an invoice factoring agreement, you authorize the factor to collect payments from your customers. In fact, most factoring companies require you to change the payments to their name.
When you turn your invoices over to a factoring company:
You have no control over how the factor will collect those invoice payments.
Your customers may be subjected to robocalls from the factoring company.
Your customers might face unfamiliar invoices, personnel, payment terms and payment methods.
While the payment process between the factoring company and your customer may go smoothly, there is a chance that it might not. Problems between the factoring company and your customers could put a strain on your business relationship with your customers. That’s a risk you take when you send invoices to a factoring company.
Further, your payments, when paid to you directly by your customers, aren’t commingled with those of other businesses, which makes your record-keeping easier. This isn’t the case when payments are in the name of the factoring company. In fact, it’s not uncommon for factoring companies to misapply your customer payments to another business, which means you still have to closely watch all payments and reconcile them on your end.
Why early payment programs are a better alternative to invoice factoring
As an entrepreneur trying to build your business, you need access to financing to improve your cash flow — but with better terms and prices than many factors offer.
Although invoice factoring can appear to be an attractive solution to bridge a funding gap and a quick way to improve your working capital, there are several drawbacks to carefully consider before jumping into a factoring agreement. Not only is invoice factoring one of the most expensive ways to increase your cash flow (APRs can reach 30% or higher), but it is also a less versatile financing option compared to debt-free alternatives, such as an early payment program.
Opting into an early payment program with dynamic discounting can enable you to get paid faster and free up cash that would otherwise remain tied up in accounts receivable. Plus, early payment programs don’t require you to take on new debt, enter a complicated contract or compromise your customer relationships.
While early payment programs share a commonality with invoice factoring, in that both solutions discount invoices to give you access to your cash, early payment platforms allow you to maintain ownership of your invoices and access capital on your own terms. That means you retain control over your invoicing and collection practices at a fraction of the cost. Moreover, early payment solutions such as C2FO’s can save your business up to 70% on the cost of working capital.
Are you interested in using an early payment program to increase your cash flow? Learn more or get started by searching for your customers today.
This article originally published October 2019, and was updated January 2023.