Education Library · Financing Tools · Article 4
You finished the job and sent the invoice. Now you wait 30, 60, sometimes 90 days to get paid, and payroll is due Friday. That gap between doing the work and getting paid is one of the most common cash flow problems in the trades, especially for owners who do commercial work. Invoice factoring is one way businesses close it.
What factoring is
Factoring isn’t a loan. You sell your unpaid invoices to a company called a factor, at a discount, in exchange for cash now.
In a typical deal you do the work and send the invoice, then sell that invoice to the factor. The factor advances most of the amount, often 70% to 90%, within a day or two. Your customer pays the factor directly instead of paying you, and once they do, the factor sends you the rest minus its fee. On a $10,000 invoice with an 85% advance, you might get $8,500 up front and the remainder, less fees, when your customer pays.
Your customer will usually know
Because your customer pays the factor, factoring is usually visible to them. The invoice will tell them to send payment somewhere new, and the factor may call to confirm the invoice is valid. In some industries that’s routine. In others it can change how a customer sees you, so think about that before you start.
What it costs
Factors usually charge a percentage of the invoice for each period it stays unpaid, commonly somewhere between 1% and 5% per 30 days. Some charge a flat fee instead. Many add application fees, processing fees, monthly minimums or penalties for ending the agreement early.
A few percent a month doesn’t sound like much, but 3% for every 30 days works out to an annual cost well above what a bank line of credit charges, and if your customer takes 60 or 90 days to pay, the fee keeps adding up. Ask for the total cost on one of your real invoices, start to finish, with every fee included.
Rates vary more than most owners expect. An underground utility contractor we work with was factoring invoices to a large prime contractor that paid on net 60 terms. The factor was charging 3% per 30 days. When the company shopped it, another factor offered 1.56% on the same kind of receivables.
Recourse and non-recourse
With recourse factoring, if your customer doesn’t pay, you have to buy the invoice back or replace it. Most factoring is recourse, and it’s usually cheaper. With non-recourse factoring, the factor takes on some of the risk that your customer doesn’t pay, but usually only when the customer can’t pay because of insolvency or bankruptcy. If your customer refuses to pay because of a dispute over the work, you’re often still on the hook. Non-recourse costs more.
How the contract handles an unpaid invoice matters as much as the rate. When Paul reviews a factoring offer, this is one of the first things he looks for: “what happens if the money is not collected… Does the factoring company take your side or do they essentially sue you and go after you instead of going after the company that didn’t pay you?” Some factors make the first collection call to your customer and work the problem with you. Others turn on the business as soon as a payment is late. In Paul’s words, “The contracts will kind of show you if they’re going to be a friend or a foe if things kind of go sideways.”
Approval depends on your customers
Factoring approval is based mostly on the creditworthiness of the businesses you invoice, not on your own credit. That’s why it can be available to newer companies or owners with damaged credit. An electrical contractor we work with had steady work with a large food processing company running around the clock, and he worried that his smaller purchase orders would look weak to a factor. Size wasn’t the issue. Approval came down to how the work was billed and whether that customer reliably pays.
It also means factoring only works when you invoice other businesses or government agencies.
Where factoring doesn’t fit the trades
A residential HVAC or plumbing company that collects from homeowners at the end of each call doesn’t really have invoices to factor, and factors generally won’t buy invoices owed by individual consumers.
Construction has its own problems. Factors are often cautious with construction receivables because of progress billing, retainage held until the end of a project, lien rights, pay-when-paid clauses and disputes over completed work. Some won’t touch construction at all, and others will at a higher cost with more paperwork. Factoring tends to fit trades businesses doing commercial service work, working for property managers or general contractors with solid payment histories, or holding government contracts.
When an MCA is already in place
If you have a merchant cash advance, factoring may not be available. MCA agreements usually give the MCA company a claim on your future receivables, and a factor needs to be first in line on the invoices it buys. A government contractor we talked with had three jobs stalled for lack of working capital. Factoring is a standard way to fund government work, but as he put it, “I can’t do factoring when I have MCAs.”
What to check in the agreement
Look for how long the contract runs and whether there’s a monthly minimum, whether you have to factor all of your invoices or can choose, what lien the factor files (often a UCC lien, sometimes a blanket lien on all business assets), and what it costs to leave.
Factoring can also affect what comes next. A factor’s UCC lien can complicate a bank line of credit, and under current SBA rules SBA loan proceeds can’t be used to pay off a factoring agreement. That’s worth thinking about before you start, especially if a bank loan is part of the plan in the next year or two.
This article is educational and isn’t legal, tax, accounting or lending advice. Program rules, lender terms and credit bureau practices change, so verify current terms before acting.
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