How invoice factoring works: advance rates, fees and recourse

Selling an invoice for cash now

You finish a job, invoice your customer on net-60 terms and sell that invoice to a factor. The factor advances most of the face value within days, collects from your customer when the invoice comes due, then releases the balance to you after taking its fee. Your customer is called the account debtor, because it owes the money.

Because the factor is buying the invoice, the deal turns mainly on your customer's credit, not yours. Article 9 of the Uniform Commercial Code covers the sale of accounts as well as loans secured by them, which is why a factor may file a UCC-1 financing statement on your receivables. Invoice factoring suits businesses that sell to other businesses or to government, where payment terms of 30 to 90 days are common.

The 4 numbers in every factoring deal

• Advance rate. The share of the invoice paid up front. Porter Capital says it offers advance rates of 85% to 90% depending on risk, and Big Think Capital and Spartan Capital Group both advertise advances of up to 90%.
• Fee. Porter Capital says its fees are typically between 1% and 4% per 30 days. Big Think Capital quotes factor fees of 1% to 5% of invoice value.
• Fee period. Some fees are flat; others step up for each period the invoice stays unpaid. Big Think notes that many programs charge a tiered fee that increases the longer an invoice goes unpaid. Check whether the fee is charged on the invoice's face value or on the amount advanced.
• Reserve. The part of the invoice not advanced, held until your customer pays. New York's disclosure rules define it as the difference between the purchase price and the original advance. Porter Capital describes the release this way: once payment is received, the reserve, minus fees, is released to you.

Worked example: a $40,000 invoice to a GC

The slower your customer pays, the more you pay, so factoring costs follow your customers' habits. A GC that always pays on day 75 is a different deal from one that pays on day 40, even at the same fee.

Recourse vs non-recourse

In recourse factoring, the risk that your customer never pays stays with you. Big Think Capital describes the common setup: you repurchase invoices still unpaid after 90 days. Non-recourse factoring moves credit risk to the factor. Big Think describes it as the factor absorbing credit losses from insolvent customers, typically at a higher cost, and Porter Capital offers non-recourse facilities for approved debtors only.

Read how the contract defines a non-recourse event. Protection against a customer's insolvency is not protection against a customer who refuses to pay because it disputes your work, and a buyback demand on a large invoice can arrive when cash is already short.

Notification and your customers

The UCC sets the rule. Until the account debtor receives an authenticated notice that the invoice has been assigned and that payment goes to the assignee, it can discharge the debt by paying you. After the notice, only payment to the factor counts. Big Think notes that most programs are notification factoring, with customers paying the factor's lockbox.

In practice, tell your key customers before the first notice arrives and update the remit-to details on your invoices. A customer that keeps paying you after notice may have to pay twice, and it will remember whose paperwork caused the problem.

Factoring vs invoice financing

Both count as commercial financing under the disclosure laws in states such as New York and California, which cover factoring transactions alongside loans and merchant cash advances.

Factoring vs an MCA for B2B businesses

An MCA is priced on your deposits and your risk, and its cost is fixed however quickly the money comes back. Factoring is priced on your customer's credit and runs only as long as the invoice is open. In the example above, the subcontractor paid $1,600 to use $34,000 for 52 days. A $34,000 MCA at a factor rate of 1.35 would cost $11,900, whatever day the GC paid.

The trade-off is reach. Factoring can only advance against invoices you have already issued, so it cannot fund a new truck or a slow retail month. An MCA can, because it is sized on deposits rather than receivables.

Contract terms to check

• Do you choose which invoices to factor, or must you factor every invoice from a customer?
• Is there a minimum monthly volume, and a fee if you fall short of it?
• How long is the agreement, and is there a fee to terminate early?
• Are there extra charges for wires, credit checks on your customers or lockbox processing?
• When is the reserve released: when each invoice is paid, or on a weekly or monthly schedule?

When factoring makes sense

• Good fit: staffing firms paying workers weekly on 45-day client terms, trucking companies waiting on broker payments, and subcontractors waiting on GCs.
• What factors check: Big Think lists 3 months in business, $25,000 to $50,000 or more in monthly factorable invoices, and B2B or government invoices to creditworthy customers, with personal credit not a primary factor.
• Poor fit: sales to consumers, invoices your customers often dispute, or margins below what a fee of 2% to 4% a month would consume.

Run your own invoices, advance rate and fee schedule through the factoring calculator to see the cost at your customers' real payment speeds.