Factoring is a financial exchange in which a company sells its outstanding invoices to a third party company at a reduced price or for a percentage of the value. It's also called invoice discounting by some people, but these things are not exactly the same thing so do be careful.
Companies do this because it means they get the bulk of the money up-front, rather than waiting for the invoices to be paid. Waiting can cause debts and cash flow problems, which can be serious for business, limiting their ability to buy stock, pay debts and in some cases carry on trading.
A regulated cash income is essential to some businesses and this is what using a factor firm provides. You'll be able to release cash tied up in unpaid fees, which will usually be significant sums of money. It can be a cheaper form of business finance than an overdraft or loan for many companies.
This transaction is a form of business finance, but it is different to taking out a loan. It is based on the money which is demonstrably owed to a business, not its credit score like a bank loan, for example, would be. The factor is in essence buying an asset, rather than lending money.
The factor pays slightly less than the full amount of the invoice in recognition of the fact that, with the invoice still unpaid, they are taking on a level of risk. The third party firm will usually bill the customer directly, so you should consider whether you mind this. Some businesses prefer to deal direct with their clients to maintain good relations.
When choosing a factoring firm, therefore, you will need to make sure that you're happy with their customer service and communications - essentially they will be contacting your clients on your behalf so you need them to make a good impression.
Although with this type of finance you get some money up front, which is its major advantage, you will only get a percentage (an advance), rather than the full value which the company has agreed to buy the invoice for. This minimises their risk. This will be paid when the invoice is submitted.
The next instalment is paid when the invoice is settled in full. Sometimes, as well as the charge or discount for buying the invoice, the firm will also add a charge for interest if the invoice is paid late.
Not all business are eligible for this process. You must, for example, sell to other
business, not consumers. You'll also usually need to have an annual turnover of at least ?100,000. Sometimes smaller businesses will be considered though, but your business plan and finances are likely to be scrutinised in detail.
You also usually won't be eligible if you issue lots of invoices for small amounts. Typically, ideal businesses deal with two or three large clients that they issue big invoices to. Otherwise, the process simply isn't cost effective for the factor firm.
