As a small business owner, you may find yourself in need of quick cash during periods of slow business or when you’re trying to get your operation up and running. However, it can be difficult to secure a small business loan when you’re just starting out, and high interest rates can be crippling in the early years. Instead of a conventional loan, consider factoring when your business needs funds.
Factoring provides a small business easy access to a flow of cash by offering an advance on unpaid invoices. There are two types of factoring available to business owners, and it’s important to understand the difference between jumping in feet first.
What Is Factoring?
In its simplest form, factoring allows your small business quick access to cash owed on unpaid invoices without waiting for it to be paid by the customer on the due date. The advance from the factor is typically 70 to 80 percent of the unpaid invoice. Once the invoice is paid by the customer, the factor remits the remaining payment. The factor will also charge the small business a small transaction fee for their help.
There are two common types of factoring: recourse and non-recourse. FSW Funding is a recourse lender, meaning that we advance funds to small businesses against invoices. We do not purchase accounts receivable, but we do help businesses who need to borrow money against their invoices.
Non-recourse factors requires the factor to purchase a business’ accounts receivable, which is the total amount owed to a business by customers. The factor then pay cash to the small business based on that purchase. The amount paid is 85% to 90%, with the factor keeping the remaining amount when the invoices are paid.
In recourse factoring, a factor provides a small business with a partial cash advance on an unpaid invoice. As with all factoring, the customer pays the factor directly and the factor pays the remainder of the invoice to the business, less the transaction fees charged by the factor. However, if a customer fails to pay an invoice within a set period of time, the small business is responsible for buying the invoice back from the factoring company. This makes the transaction low-risk for the factoring company, allowing for lower transaction fees for the small business.
The vast majority of factor companies offer recourse factors because the transaction requires less risk for the factor. The lender has the ability to collect money from any unpaid invoices from the small business. This means that the borrower takes on all the risk of invoices that go unpaid by customers.
This higher risk for the borrower doesn’t mean that recourse factoring is a bad option for small business owners. If you know your small business customers are highly likely to pay their invoices, you know the risk is low with a recourse factor. Knowing your customer is very helpful when deciding between a recourse and non-recourse factor. Small businesses can also benefit from recourse factoring because, despite the risk of having to pay back the factor for unpaid invoices, the transaction fees are low enough that little money is spent on cost of capital.
The major benefit with recourse factoring is that, since transaction fees are tied to risk level, your business will pay a lower transaction fee to the factoring company. Recourse factoring is also very common, so it’s simple to find a factoring company that can work with your small business.
The drawback of recourse factoring is that if an invoice goes unpaid, your small business must pay back the factor the amount of the unpaid invoice. This creates more risk for your small business because you could end up faced with repayment at an inopportune time.
The first thing that you need to know about non-recourse factoring is that it’s not considered a loan. It should be considered off-balance sheet financing. The major difference between recourse and non-recourse factoring is that with a non-recourse factor your small business doesn’t have to pay back the factor for unpaid invoices. Your small business gets to keep the cash advance as long as the invoice that has gone unpaid is unpaid for reasons such as your customer went out of business. The cash advance will have to be paid back to the factor if the reason the customer didn’t pay is due to defective product.
Non-recourse factoring is high-risk for the factor due to the likelihood of fraud and risk of customer non-payment. Because of this, if you’re interested in non-recourse factoring, expect that your business and your customers will be thoroughly investigated to ensure likelihood of payment. The more risk that is assessed for the lender or factor, the higher the transaction fees will be.
The big benefit with non-recourse factoring is that your small business isn’t required to pay back unpaid invoices if your customer fails. The factor takes on the risk of losing money from unpaid invoices.
The negative with non-recourse factoring is the transaction fees. Because the risk is higher for the factor, it raises the transaction fees that your small business must pay. This type of funding is also more rare, which may make it hard to find a factor willing to work with you in non-recourse factoring.
When to Use Each Factoring Type
You’re probably wondering if recourse or non-recourse factoring is right for your small business. It’s important to really assess your business and the personality of your customer before making this decision. It’s not uncommon for a small business to need a cash advance during a slow time of business or to make improvements to the business. If you know that your customers always pay invoices, recourse factoring will have very little risk for your business. If your customers often pay late or not at all, non-recourse factoring may work better for your business.
With either factoring type, your business will be responsible for paying transaction fees, which means you won’t receive the full amount due for an invoice. Make sure to assess your finances and decide if the benefits of the immediate cash outweigh the fees that must be paid to the factor.
FSW Funding specializes in helping small businesses find immediate funding using flexible and affordable recourse factoring. Let us help your business to find the right type of funding to manage your needs and growth.