What You’ll Learn:
- A step-by-step guide to invoice factoring
- The costs, risks, and benefits of invoice factoring
- Why Hopscotch Flow is smarter choice for small businesses
Small, service-based businesses operate at the mercy of invoices with long net payment terms. These types of businesses sometimes have to wait months to get paid, keeping a careful eye on the time gaps between accounts payable and accounts receivable. At the same time, they have to protect valuable client relationships. That means chasing down payments or asking awkward questions about overdue invoices is usually not the preferred course of action—even when they desperately need a payment to come through on-time.
So what’s the best solution when small businesses need a fast infusion of cash? If clients pay late, an alternative financing option like B2B invoice factoring can provide relief. However, it’s not the only cash flow solution out there and the risks might outweigh the benefits in some scenarios.
What is cash flow?
In simple terms, cash flow is the movement of money into and out of a business over a specific time period. It’s measured based on income (earnings like revenue from sales and services rendered) and outgoing expenses (like operational costs and staff salaries.)
Small businesses, freelancers, and entrepreneurs all deal with different types of cash flow challenges. For example, late payments from clients can trip up small businesses and make it difficult to manage unexpected costs. Freelancers who rely on project-based income are also vulnerable to irregular payment schedules from clients. And for entrepreneurs, the complexities of startup ventures might mean that cash flow is particularly tight during the early stages of building a new company.
Ultimately, effective cash flow management is essential for any type of small business. Having access to liquid capital when you need it guarantees you can meet important financial obligations and capitalize on growth opportunities. If your business has cash flow issues, it’s much more likely to fail. In fact, poor cash flow is the #1 killer of small businesses.
What is invoice factoring?
Gaps in cash flow create real risks for small businesses—you might not be able to pay your bills on time, which could mean incurring damaging late fees and potentially jeopardizing important client/vendor relationships. Factoring your invoices is a way to access cash from unpaid invoices and protect against the vulnerabilities that stem from poor cash flow.
Invoice factoring, or accounts receivable financing, is a form of alternative financing (meaning it’s not a loan) that involves selling your unpaid invoice to a third party factoring company in exchange for an upfront cash advance on a percentage of the invoice amount.
The factoring company purchases your invoice at a discount. When your client eventually pays that invoice, the factoring company collects the full sum. They also charge fees for their services, which we’ll cover in more detail below.
What is invoice financing?
Invoice factoring and invoice financing are often used interchangeably but there are some key differences. Invoice factoring involves selling off your unpaid invoices in exchange for funds, while invoice financing leverages your unpaid invoices as collateral for a loan or line of credit. Both are types of working capital financing.
When factoring an invoice, a third party company purchases your receivable (the unpaid invoice) and assumes responsibility for collecting payment. When financing an invoice, you maintain ownership of the receivable and use it as collateral for a loan. After your customer renders payment, you can then repay your lender the amount loaned plus any fees and interest they charge for their services.
Invoice factoring is not a loan, so some business owners may consider it a faster and more convenient way to accelerate funds from their accounts receivable. But invoice financing might be better-suited for businesses that want to maintain full control over their invoices.
Ready to instantly improve the cash flow of your business?
How does invoice factoring work?
Let’s say you own a small catering business. Last month, your team was hired to provide dinner at a conference event and the client, a digital marketing agency, owes you $12,000 for the night. You need some of the money from that invoice to pay one of your suppliers for an upcoming seafood order. You also need to make payroll for your waitstaff (and pay yourself at some point).
The terms on the invoice are net-30, and it’s technically only been 20 days since you sent the invoice. The event went really well and you think that client might hire you for future work, so you don’t want to jeopardize the relationship with an awkward question about when they plan to pay you. But at the same time, you need access to that cash ASAP.
Lots of small, service-based businesses deal with complicated cash flow scenarios like this every day. Here’s how the invoice factoring process might play out for the catering business in this example:
- You provide services to your customer and send them an invoice.
- Instead of waiting for your customer to pay, you sell that receivable to a factoring company at a discounted rate. In this case, the factoring company agrees to purchase the invoice for a fee of 3% the total amount every month until your customer pays.
- The factoring company then advances you a portion of the total invoice amount, usually around 80-90%. 80% of $12,000 is $9,600, so let’s say that’s the cash you get upfront.
- The factoring company now owns that receivable and takes responsibility for collecting full payment from your customers.
- Your customer is informed that you factored their invoice, and alerted to send payment to the factoring company rather than your business.
- Your customers pay the full invoice amount 10 days later. The factoring company deducts its fees (3% of the invoice amount or $360, plus any processing fees and credit check fees) and gives you the remaining balance.
Is invoice factoring risky for small businesses?
There are clearly some advantages to factoring an invoice and getting paid early, especially for small businesses in B2B (business-to-business) industries. But is invoice factoring a good idea? Here are some upsides and downsides to keep in mind.
Pros of invoice factoring:
- De-risk your business. The stress of outstanding receivables can weigh heavily on a small business owner. Not having the flexibility to cover expenses or invest in opportunities that arise unexpectedly can jeopardize growth.
- Offer longer net payment terms. On top of smoother cash flow, traditional factoring also gives small businesses the opportunity to extend longer net payment terms to loyal customers and maintain strong relationships.
- Qualify quickly. The approval process for invoice factoring is based largely on the creditworthiness of your customers and the value of your invoices. If a business is struggling to secure traditional loans because they don’t have a robust credit history, factoring may be a more accessible form of alternative financing.
Cons of invoice factoring:
- If your customer fails to pay. Be sure to read the terms of your factoring agreement to understand which party is ultimately responsible for accepting the loss—you or the factoring company—in the event that your customer fails to pay. With recourse factoring, your business is still on the hook if your customer fails to render payment.
- Fees can add up. On top of the service fees, some factoring companies also have hidden fees that may get passed along to your business. For example, fees for any credit checks run on your customers might wind up coming out of your pocket.
- No privacy. Once you factor an invoice, the payment collection responsibility is often transferred to a third party. This means you give the factoring company permission to pursue payment and sacrifice a certain amount of visibility into the customer experience.
How much does it cost to factor an invoice?
In exchange for taking on the risk of your receivable and advancing cash to your business, invoice factoring companies tend to charge a flat rate on a recurring basis until your customer sends payment.
That flat rate ranges from 1% to 5% of the invoice value depending on variables like your customer’s creditworthiness, the invoice amount, and your sales volume. This rate is not usually a one-time fee. Factoring companies typically collect on a per month basis until your client pays the invoice. There are additional hidden costs to look for as well, like credit check fees, processing fees, and late fees.
How does Hopscotch Flow compare? Businesses that use Flow to get paid early receive a dynamic rate that improves over time as you build a transaction history with Hopscotch. There are no hidden fees.
How long does it take to factor an invoice?
While factoring an invoice is quicker than securing a traditional business loan, there are still some hoops to jump through and the cash flow infusion isn’t immediate.
You’ll typically need to submit an application and go through a round of evaluation by the factoring company before they approve your request. This process can include background checks on your business as well as on the clients whose invoice you’re looking to factor. The goal is to prove that the transaction is legitimate and verify that the receivables are valid before agreeing to advance funds.
All in all, the timeline for factoring an invoice typically takes at least a week.
How does Hopscotch Flow compare? With Hopscotch Flow, you can find out if your invoice is eligible immediately and get paid instantly. Advance funds in minutes rather than days, and get back to running your business.
Will invoice factoring affect my client relationships?
Invoice factoring is a powerful financial tool. However, it’s important to note the risks. The potential impact on customer relationships due to third-party involvement in payment collection can be significant.
Once they own your receivable, traditional factoring companies usually manage the collection process. This means they can directly interact with your customers about payment status, and you won’t have visibility into those conversations or experiences. Some business owners might see this as a risk. For others, handing off the stress and distraction of following up on payment status might be appealing and give them more time to focus on operating their business.
Factoring companies will also run a credit check on your customer, which can create tension.
How does Hopscotch Flow compare? Your clients won’t know when you choose to Flow an invoice, and your privacy is guaranteed when you use Flow. There are no credit checks required for your business or your clients.
What documents do I need to provide for invoice factoring?
Working with a bank or lender can be time-consuming. You typically have to provide extensive financial documentation (things like income tax returns, profit and loss statements, and cash flow statements), then wait weeks and sometimes months to get approved.
Selling your invoices doesn’t require nearly as much paperwork. You’ll need to provide some basic details about your business—identifying documents like articles of incorporation, your business bank account, your tax ID number—and the invoices you want to factor.
You also need to provide the factoring company a report on your accounts receivable history, usually going back about 90 days. This will give them a sense of the risk involved before agreeing to take ownership of collecting payment on any outstanding invoices.
How is Hopscotch Flow different from invoice factoring?
Hopscotch Flow is an alternative to both traditional invoice factoring and invoice financing. You get all the advantages of flexible cash flow management at greater speeds and more affordable costs with fewer downsides.
More cash upfront. Hopscotch Flow offers a 90% advance rate so you can get the majority of your invoice amount upfront; the remainder will be paid out once your customer pays (less fees.)
Faster access to capital. With Flow, small businesses can unlock capital from unpaid invoices on-demand. Find out if your invoice is approved immediately and get paid in 2 clicks.
No credit check. There’s no credit check required to use Hopscotch Flow for you or your customers.
No hidden fees. Traditional factoring can become costly if your customer takes a long time to repay. With Flow, you don’t have to worry about hidden fees like application fees, processing fees, or credit check fees.
Privacy guaranteed. Flow also gives you the confidence of protecting customer relationships (privacy guaranteed) without having to manage the collection process.
Best-in-class payment experience. Small businesses can trust Hopscotch to manage and maintain smooth payment experiences for their customers.
Find out if your invoice qualifies for Hopscotch Flow
Need to get paid instantly? Use Hopscotch Flow to advance funds from unpaid invoices in just 2 clicks. Flow offers all the cash flow convenience of invoice financing with fewer downsides for small businesses. There’s no credit checks for you or your customers, Flow is completely private, and you can get paid immediately instead of next week.
Start your free trial with Hopscotch here and see which of your invoices qualifies for Flow!
Bret Lawrence
Writer
Bret Lawrence writes about invoicing and cash flow management at Hopscotch. Her previous roles include senior financial writer at Better Mortgage, where she covered lending and the home buying process. Her writing is not financial advice.
