What is the definition of receivables factoring?
Receivables factoring, also known as accounts receivable factoring, is a type of business financing in which a company sells its receivables (invoices) to a third party at a discount to raise capital. The recipient of the funding then pays back the financier over the following six to nine months.
The main advantage of receivables factoring is that it allows companies to receive cash sooner than they would if they waiting for customers to pay their invoices. This can be helpful for companies that need funding for OpEx or for those looking to make a strategic hire or acquisition.
How are receivables factoring contracts structured?
There are a few flavors of receivables factoring, but the most common is the sale of individual accounts receivables (invoices) to an investor or financier at a discount. When receivables are sold, the business receives an infusion of capital that can be deployed to fuel its growth or fund its Op Ex overhead. The financier then assumes the responsibility for collecting payment from the borrower. Typically, financiers will advance between 50-90% of the invoice value to the borrower, minus a factoring (origination) fee.
What are the common use cases for receivables factoring?
Businesses use receivables factoring for several reasons, including:
- Free up working capital: When businesses sell their receivables, they don’t have to wait for future payments—they can immediately leverage the cash to fuel their growth and operations.
- Avoid taking on debt: Receivables factoring is similar to debt, in that it must be repaid, but it is not debt, and typically is not senior in the capital stack.
- Improve cash flow: For businesses with annual contracts, receivables factoring can help improve cash flow constraints during periods of slowing sales.
When should a startup consider using receivables factoring?
Receivables factoring can be used by businesses of all sizes, however, it is typically most helpful for recurring revenues or those with annual contracts. While there is no right or wrong time to use this form of financing, businesses typically turn to it when they are:
- Experiencing cash flow issues
- Unable to obtain traditional financing or venture debt
- Looking for a fast source of financing
- Looking for a way to free up working capital
- Wanting to take advantage of early payment discounts from suppliers
Can you provide an example of receivables factoring in action?
Suppose business XYZ sells software to customers on credit. One of XYZ’s customers, ABC Corporation, has an outstanding balance of $10,000. XYZ’s terms with ABC Corporation state that payment is due in 120 days.
Company XYZ could wait for ABC Corporation to pay its invoice and receive the full $10,000. However, company XYZ may need the cash sooner to cover its operating expenses or to hire an additional salesperson.
In this case, company XYZ sells their accounts receivable at a discounted rate, say $9,500. The financier advances company XYZ the $9,500 minus an origination fee. Each month company XYZ pays the financier a set fee until the full $10,000 is repaid.
What are the pros of raising capital via receivables factoring?
There are several advantages to raising capital via receivables factoring, including:
- Get access to capital quickly: Typically capital is provided within 3-4 days from financers through receivables factoring.
- Smooth out cash flow: Typically businesses with annual contracts have lumpy monthly revenues which makes capital planning more complicated. To smooth out its cash flows, a company may consider selling its invoices.
What are the cons of raising capital via receivables factoring?
Although there are some advantages to receivables factoring, there are also some cons to consider, including:
- Not all receivables may qualify for factoring: Factors typically only finance invoices from creditworthy customers. This means that you may not be able to get funding for all of your accounts receivables.
- You may have to pay a higher interest rate: While there is no traditional interest rate with receivables factoring, there is a discount rate, which could be thought of similarly. Because this is a type of short-term financing, you may have to pay a higher interest rate than you would with a long-term loan.
What are the typical terms of receivables factoring?
The terms of receivables factoring can vary depending on the financier you use. However, some common terms are typically associated with this form of financing, including:
- Discount rate: The discount rate is the percentage of your invoices that the factor will finance. For example, if you have an invoice for $100 and the factor has an advance rate of 80%, you would receive $80 in funding (before fees).
- Factoring fee: The factoring fee is the fee charged by the financier for providing financing. This fee is typically a percentage of the invoice amount and is paid when you receive funding.
What are the differences between receivables factoring and receivables financing?
Receivables financing and receivables factoring are both ways to get funding based on your future accounts receivables. However, the key difference lies in the underwriting process and the collateral that is required.
With receivables factoring, you are selling individual invoices, so if a customer churns, you need to replace it with an in-kind receivable. However, with receivables financing this is not the case, since individual invoices don’t matter, rather you just need to make the monthly payments. Also, typically receivables factoring is more expensive than receivables financing in terms of both the discount rate and the factoring fees.
What are the financing alternatives to receivables factoring?
There are several financing alternatives to receivables factoring, including:
- Venture Debt: Venture debt is a good alternative to receivables factoring if you have recently raised a round of equity financing and need a longer repayment period.
- Line of Credit: If you need a revolving credit facility that you can pay down over time, a line of credit may be a good alternative.
- Revenue-Based Financing: Rather than listing and selling individual invoices, with revenue-based financing, the entire business and all of its revenues are underwritten, resulting in larger facilities with better terms. Learn more here.
Can you negotiate the terms of receivables factoring?
Yes, you can and should negotiate the terms of receivables factoring including the repayment tenure, the discount rate, and the origination or factoring fee.