It is very common for small businesses to struggle with cash flow. A majority of small businesses report financial challenges, with cash flow management ranking among the most common pressures faced by growing firms.
Even with strong sales, if you don’t have enough liquidity in your business throughout the month, or if there are peaks and valleys, meeting financial obligations can be challenging.
At the heart of this is often the need to wait 30 to 90 days for customers to pay invoices. That creates real financial strain. It can limit investment opportunities and create rifts when vendors are not paid on time.
Invoice factoring is an opportunity to access cash that’s tied up in those unpaid invoices sooner. Of course, this is not free money. There are costs related to tapping into those funds before the customer pays the invoice. And, it is not right for everyone. However, for many small businesses, it can be a viable resource.
What is invoice financing?
Invoice financing allows a business to obtain payment now, before the customer pays the debt. It allows the business to tap into outstanding, unpaid invoices now rather than waiting for the customer to make payment in 30 to 90 days.
Invoice financing allows businesses to borrow against unpaid invoices. The invoice itself becomes collateral for the debt. This is a common scenario for B2B businesses that issue invoices to customers and then must wait for payment to come in, often weeks later.
With invoice factoring, you continue to collect payment from your customer, though some forms allow for the lender to take over managing the customer collection efforts.
How does invoice factoring work?
Invoice financing has three components. The first is a business that issues the invoice, the customer who must pay that invoice, and a financial service company. Here is what occurs in the typical situation.
Step 1: Issue an invoice to the customer
The customer makes a purchase from your business. The customer has an agreed payment term in their invoice, such as net 30 or net 60. Once the customer makes the purchase, the customer receives an invoice. That invoice is money already earned by the business.
Step 2: Apply for invoice financing
The business submits the invoice to a financing provider. The financial services company will evaluate the customer’s ability to pay. That is not just the businesses’ qualifications but the customer’s likelihood of paying the invoice within the timeframe expected.
Step 3: Receive an advance
Once approved, the provider will advance a percentage of the total invoice value to the business. The business can use those funds in any way necessary. The remainder of the invoice is held back until the invoice is paid by the customer.
Step 4: Invoice gets paid
The customer pays the invoice according to the original terms. Once paid, the financing provider deducts its fees. The business then receives the remaining balance if the financial provider still owes additional funds.
Notably, the amount received is typically a percentage of the total owed on the customer invoice. That percentage is dependent on numerous factors, including the risks involved.
Invoice financing vs invoice factoring
Invoice financing allows the business to maintain control over the customer relationship. The customer often does not know that the business is using financing. Some providers will require this, but not all.
Invoice factoring occurs when the financial service provider collects the payment directly from the customer. The customer typically knows about this relationship. In invoice factoring, the lender purchases the invoices from the business.
Invoice financing for LLCs vs sole proprietors
Business structure can play a role in whether you can use invoice financing. Each financing provider sets their own rules for what types of businesses it will work with, based on factors like the perceived strength and risks associated with those organizations.
Both LLCs and sole proprietors can qualify for invoice financing. However, LLCs often appear to be more established to providers, and that may open the door for more opportunities to secure funding.
No matter the structure of your business, financing services will put most scrutiny on the customer. They must be legitimate and collectible. If there is any question about the validity of the debt or the customer’s ability to pay the invoice, financing providers are less likely to move forward.
In some situations, including in both LLCs and sole proprietorships, providers must require a personal guarantee. That means you may still maintain responsibility for the funds even if the customer does not pay the invoice.
Invoice financing for startups
Invoice financing may be available to start-ups. However, as with any other business, the financing provider wants to understand the risks involved. A startup may qualify if it has:
- B2B customers, meaning businesses owe you money
- Customers who are established and reliable
- Invoices are already issued
In these situations, invoice financing will focus on the customer’s likelihood of paying rather than the state of the business. However, invoice financing does not help if you do not have invoices yet or if your customers are consumers. It also doesn’t replace consistent revenue. Rather, it supports financial gaps in cash flow.
When using invoice financing, view it as a cash flow tool. It is not startup capital and cannot operate in that fashion.
What invoice financing can be used for
There are numerous ways a business may use invoice financing. As a cash flow financial tool, it may help with:
- Paying vendors and payroll
- Covering operating expenses for the business
- Bridging gaps between billing and payment
- Managing growth-related cash flow strains
This is best for a short-term supportive tool that can help your business get ahead of the cash flow limitations it is currently facing. It does not support significant long-term financing or expansion of financial needs.
Pros and cons of invoice financing
Pros
For businesses with a need for cash flow, invoice financing offers a number of benefits:
- It’s typically far faster to cash than traditional business loans, taking hours and days rather than weeks or months.
- There is less focus on the business’s creditworthiness. More of the focus is on the customers’ ability to pay their invoices.
- The value borrowed can scale as your business grows and revenue volume increases.
Cons
Used improperly, invoice financing can be troublesome and limiting:
- Used for immediate needs, it can be helpful, but maintained over time, it can be very expensive.
- Fees can add up if customers take too long to pay invoices.
- It is not suitable for all business models and is not meant to be startup capital.
- Overuse can signal a deeper financial concern, including cash flow and liquidity issues within the business.
As a business, consider the use of any type of financing carefully, comparing the immediate and long-term financial implications, costs, and availability. Invoice financing is often suitable for short-term needs when customers already owe you money.
Risks and common misconceptions
The rather unique structure of invoice financing creates some confusion. It’s critical not to see this type of financing as a traditional loan. It comes with its own limitations and opportunities.
“It’s not a loan” ≠ no cost
One of the most important misconceptions is that invoice financing isn’t a loan and therefore comes at no cost or risk to the business. There are costs associated with the process, and overuse of these financial tools can dip into profits and overall financial well-being for the business.
Fast access ≠ cheap financing
Fast access does not mean cheap financing. One of the best benefits of these financial tools is that you can secure the funds very quickly. However, that speed comes at a price. Carefully consider what the costs are and how much value the borrowed funds provide to your business at any given time before investing.
Reliable customers matter more than revenue size
You need reliable customers to meet your ongoing financial needs and keep your business operational. However, revenue matters, too. Cash flow gaps that continue on may mean that your business has taken on too much debt or may not have a viable, profitable structure. This may require refinement.
It doesn’t fix pricing or collection problems
If your business is operating with numerous financial limitations, such as having prices that are too low to turn a profit while meeting all obligations, invoice financing will not help your business. It also does not help your business if you are having trouble collecting from your customers. If your customers are consistently late or they are well beyond the invoice terms already, the financial provider isn’t likely to take on the debt.
When invoice financing makes sense (and when it doesn’t)
Invoice financing is beneficial when your company:
- Is a B2B organization
- Has predictable invoices you expect to be paid
- Has cash flow gaps that are short-term and temporary
It may not make sense to your business if your company:
- Has very thin margins without a lot of profit built in (meaning the fees associated with invoice financing will cut into profitability)
- Customers are slow payers, non-payers, or unknown
- Financing becomes a permanent crutch, and you continue to turn to financing offers to meet ongoing needs
Getting your business ready before using invoice financing
There are certainly benefits to utilizing invoice financing, but getting the best terms and conditions and access means working to establish a strong business foundation to demonstrate your company’s reliability. To do that, focus on these areas before you consider invoice financing:
- Put in place a clear business structure, typically an LLC, when you wish to create a clear division between your personal and business assets and debts
- Obtain an EIN
- Organize and maintain accurate accounting of all invoicing and contracts
- Keep personal and business finances fully separate
- Create clear customer records and payment terms, ensuring invoices represent those terms
Platforms like Tailor Brands can help you, as a business owner or founder, to set up and stay organized. This does not guarantee financing approval or funding through invoice financing. It does provide an opportunity for you to show your business’s credibility.
Conclusion
Invoice financing can help your business manage cash flow gaps, but it is never a replacement for strong financial fundamentals. If you’re a B2B organization with reliable customers that typically pay on time, invoice financing can work to fill in those gaps. However, you must consider the costs and risks associated with the process, and decide when you can put your best foot forward.
Remember that the right funding choice will depend on your business. That includes how your business earns and collects revenue.