When a company needs working capital, typically they will reach out to traditional banks to try and secure a small business loan. What many companies learn as they go through the small business loan application process, is that it is not easy to receive approval. It takes a significant amount of time, effort and documentation collection to even apply for a small business loan.
Many companies who follow through with a small business loan application process, find themselves with a rejection after all that effort and time spent.
With revenue-based financing options like invoice factoring, much of the application process is handled by the factoring company. The factoring company will require a few important documents. to access an applicant’s company, but the process can be completed in a matter of days instead of weeks or months.
Invoice factoring is a type of revenue-based alternative financing that is oftentimes confused with a small business loan. The reality is that the application process and the financial products are very different.
With invoice factoring, you are selling your current outstanding invoices at a small discount to a factoring company in exchange for immediate working capital for the value of the factored invoices. Typically, a company will have agreements with their customers to pay an invoice in 30, 60 or 90 days. While having a payment schedule with your customers can be beneficial for forecasting expected revenues by quarter or month, actually collecting on those invoices can be much more difficult.
Here is an example of how invoice factoring works:
Company A has an invoice that is valued at $10,000. The factoring company agrees to purchase the invoice today for $9,700 ($300 fee). The advance which for this example is 85% of the invoice value at $8,245, is than debited to Company A’s account. The factoring company then contacts Company A’s customer, collects on the full invoice amount and sends the remaining balance of $1.455 to Company A once collected.
Traditionally, small business loans require more and different types of documentation to achieve approval. With small business loans, an applicant will likely be required to provide documentation on your company’s credit history. As well as your inferred ability to repay a loan. Some of the documentation that may be required to prove revenues and thus capability to repay are sales projections, past loans repaid and current cash flows.
With invoice factoring, they creditworthiness is focused on your customers and not your business. Since the factoring company will be collecting payments for invoices directly from customers, the customer’s capability to pay off the invoice amount is more scrutinized than the company seeking factoring. This is an important distinction. Most businesses applying for financing do not have good credit thus the need for outside capital.
Alternative lending options for businesses have become increasingly popular in recent years. Oftentimes, business struggle to apply and be approved for traditional small business loans. In today’s current economic climate, with inflation rising by the day, lending from traditional banking sources will become even more scarce.
This need for small business lending has been a catalyst for a wide array of alternative financing options.
Alternative financing comes in many forms. The most important factor is whether a financing product is revenue or equity based. Equity based financing options such as crowdfunding or direct investment can inject capital quickly into your business venture. However, this will come at a cost of equity. Direct investment or crowdfunding can bring necessary working capital quickly to your accounts. However, it is essentially a trade off on future ownership or earnings.
With revenue-based financing, such as invoice factoring, a company is provided funding based upon the dollar value of outstanding invoices. This means that a company can receive working capital. Based upon business they have already invoiced, without giving up any equity in their business.
Traditionally, the most common alternative financing products base lending amounts on established revenues. A good example of a revenue-based alternative financing product is invoice factoring. The core advantage of invoice factoring is the ability to collect on the value of an invoice from a factoring company. Instead of collecting directly from the customer. Your customers might take 30 days to pay the value of an invoice. On the other hand, a factoring company will deposit the value within hours or days.
While the invoice is sold at a small discount to the factoring company, with liquidity readily available a business could focus on taking more purchase orders or expanding with new facilities or equipment.
With equity-based financing, oftentimes companies are faced with a simple decision of whether they will leverage access to short term capital, in exchange for less stake in the very business they just had funded. Working capital may be the lifeblood of a business. The cost of such working capital should be thoughtfully considered if it would mean less ownership in your own business.
Alternative financing can help prevent you from lacking working capital.
The main benefit of invoice factoring is the ability to actualize the value of outstanding invoices. This happens quickly through your factoring company.
A factoring company who is paying for invoices at the time of their issuance, will effectively replace your accounts receivable department for the invoices you factor. Simply put, when you factor an invoice through your factoring company, the working capital will be debited to your account to be used for operational or expansion purposes and the collection of those invoices is then out of your hands. For many businesses, the combination of the upfront liquidity in congruence with less accounts receivable responsibilities, allows business owners to focus on what matters to them most, their businesses.
