If you’re a founder looking to secure funding, chances are you’ve come across the term “invoice financing”. Also known as “accounts receivable financing”, “receivable financing”, or “invoice trading”, invoice financing has proven time and again to be a viable alternative route for funding, particularly to those who have trouble securing funding via more traditional means.
At a glance, invoice financing involves a fairly simple principle: borrowing money against outstanding invoices from customers. It’s an asset-based loan that allows a company quick access to funding, oftentimes so that they can improve cash flow, pay suppliers, and further invest in operations.
What is an asset-based loan?
An asset-based loan involves financing your company’s assets and using them as funding collateral. These assets can include but are not limited to equipment (such as machinery), inventory, and of course, invoices. They tend to be easier to secure compared to a bank line of credit, which is why many business founders turn to this option.
How does invoice financing work?
Invoice financing allows businesses to borrow money against what is due from their customers through a third party lender, that in turn will charge either a fee or take a percentage of the amount borrowed. It’s a short term form of borrowing that allows a company to improve its immediate working capital, which can then be used to pay for business expenses.
In the early days of a business, circumventing the need to wait until customers have paid their balances in full can help boost growth and even solve problems associated with customers who take a long time to pay.
Let’s say you sell your goods or services to a large customer, like a wholesale or retailer—most businesses do so on credit. With invoice financing, your customer doesn’t have to pay your invoice immediately, meaning your cash isn’t tied up in credit lines that could be spent on growing your operations. This will provide you with short term liquidity, and is especially helpful when looking to finance slow-paying accounts receivable.
What are the different types of invoice financing?
There are three main types of invoice financing: invoice factoring, invoice financing services, and receivable-based lines of credit.
- Invoice factoring: Invoice factoring is the simplest way to accomplish invoice financing. A business sells its outstanding invoices to a lender, who then pays up front a portion of what the invoices are worth (usually somewhere between 70% and 85%). The lender or “factoring company” purchases the invoice at a discount, and is then responsible for collecting payment from customers. Since the lender takes on the risk—say, for example, if the payments aren’t made on time—this type of lending tends to incur higher fees. This method of invoice financing is common for small businesses in the clothing and manufacturing industries, where long accounts receivable cycles are common.
- Invoice discounting (sometimes referred to as invoice financing services): This method is similar to invoice factoring, except instead of the lender collecting payments from customers, you as the company are responsible. This allows for the loan to occur without the customers being aware of the arrangement: the lender advances the invoice amount to the business (up to 95% of the total) and once the customers pay their invoices, you repay the lender—minus an agreed upon fee or interest. In this scenario, if your customers default on their payments, you are responsible for the amount that was loaned.
- Receivable-based lines of credit: This kind of invoice financing is very similar to a conventional line of credit. You draw funds as you invoice your customers, paying the line down as they pay their invoices. On average, this option allows you to borrow up to 85% of the value of your receivables, and you’ll be charged either a fee, interest, or both.
Pros and cons of invoice financing for small businesses
Is invoice financing right for my small business?
Invoice financing can offer companies the capital they need to scale to their next growth milestone. Whether that means launching marketing campaigns, hiring more staff, and investing in R&D, diverting funds towards growth at the right time can be incredibly crucial. Of course, the size of your business alongside its specific needs will dictate whether invoice financing is the right funding option for you.
The majority of B2B businesses qualify for invoice financing, as long as the company is in good financial standing. If you run a business that has a history of paying invoices on time, you’re likely a risk that most financial institutions will be willing to take on. That being said, be sure to consider all your funding options to decide which route is best for your company.