Factoring is a specialized financial service that allows a business to receive cash up front for services rendered or products delivered – without having to wait for customers to pay their bills. When you decide to sign up for factoring services with a factoring company, you will sign a factoring agreement that outlines what you can and your factoring company can expect. Agreement specifics vary, but all general invoices factoring agreements should outline the process, each party’s responsibilities, and the fees.
You can expect the following in a factoring agreement:
- A statement that the client (the owner or controller of the company wanting to sell their accounts receivable in exchange for immediate payment) confirms they will “sell, transfer, convey, and assign” selected invoices to the factoring firm
- A requirement that the client provides accurate and true financial information at all times, including accurate and true written invoices, purchase orders, or other such documents supporting the delivery of products to customers or the satisfactory performance of services
- A description of the Notice of Assignment process that notifies customers that they will send in their payments to the factoring firm rather than to the client
- A commitment for the factoring firm to provide continually updated reports on the invoices that they have purchased, the payments sent to clients, the payments received, and other information
- A description of steps taken to secure payment of any indebtedness that is due to the factoring firm in the event of default or insolvency
- A time limit for the agreement (can typically be a year)
- A fee schedule that specifies the factoring percentage rate (the amount that the factoring firm retains on an invoice to cover administrative and other costs) and the advance rate
What you will find is that the factoring rates on these agreements will depend on many variables, including the volume and dollar amount of the invoices you expect to factor. The rates will also be influenced by the credit records of your customers — not by your company’s credit history. Before granting loans, banks scrutinize your payment history, financial stability, assets and collateral, but factoring companies want to know about your customers’ creditworthiness.
Other Types of Factoring Agreements
Factoring agreements can be written for just about any business that works with invoices. Agreements will vary based on the exact types of factoring services rendered.
- Reverse Factoring: Unlike regular invoice factoring where you are dealing with batches of usually random customers, reverse factoring brings individual large accounts into the picture. This allows the factoring firm to ensure that they will be paid and allows your business to receive up to 100% of the total sum due, minus fees and charges. These factoring agreements differ in that you do not give up a percentage of the invoice total but have to pay the factoring firm a specific interest rate just as you would pay on a bank loan.
- Invoice Selling: Invoice factoring is different from selling invoices outright because if the invoices are not paid within a certain time, usually 90 days, the client is liable for the unpaid amount. Invoice factoring is also different from invoice discounting.
- Discounting Invoices: Discounting is a process in which a business uses its unpaid invoices as collateral for a loan from a non-traditional institution. The business pays only an interest rate on the loan while collecting the full amount of the invoices. The rates for discounting are usually considerably higher than a typical bank loan as well as the rate you would pay through simply factoring your invoices at a discount.
Essentially, factoring agreements allow your business — using only the unpaid invoices you already have — to get the financing you need when you choose not to take out a bank loan or line of credit.