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Small Business Finance Options – Invoice Factoring 101

Invoice factoring is a useful but often misunderstood element of small business finance. So in this article, I’ll explain what factoring is and how it can help certain business owners sustain their growth.

By way of definition, factoring is a process through which small business owners can convert accounts receivable (invoices) into much-needed working capital. Basically, there are three primary parties involved in the process:

  1. The Invoicing Company – This could be any company with accounts receivable in the form of invoices. Additionally, the company’s owner wants to convert those invoices into much-needed working capital. For this example, let’s refer to this business as “Acme Corp.”
  2. The End Customers – These are the customers who have been invoiced by Acme Corp and are thus part of Acme’s accounts receivable system.
  3. The Factoring Company – This is the financing company that specializes in providing working capital through such services as invoice factoring. This is where Acme Corp will go to try and convert their invoices into working capital, a.k.a. cash flow.

Now let’s assume that next month will bring some major equipment purchases for Acme Corp. They need two new vehicles for their business, along with some other equipment. The only problem is, a lot of their capital is tied up in the form of invoices. This represents future revenue, but it doesn’t help Acme Corp here in the present, and it won’t help them make those equipment purchases next month. In other words, those invoices are not considered working capital.

In this common scenario, a small business factoring company could step in to help Acme Corp transform their accounts receivable into working capital (which could be used to make those equipment purchases next month).

So Acme’s owner (Bob Smith) would work with a factoring company to transfer some or all of his invoices to the company. The factoring company would then advance Bob a portion of the invoice total, typically around 80 percent. Bob has just converted 80 percent of his accounts receivable into capital that he can use to cover those equipment purchases.

The end customers (the people who owed Bob those invoices) would now make payments to the factoring company, instead of sending them to Acme Corp.

This approach to financing is not for every business. Like any other financial strategy, there are many considerations that must be taken into account. But the point of this article is not to say whether or not factoring is right for your business, but merely to make you aware of this unique approach to small business finance.

Business Financing – The Internet Opens Up Unique Small Opportunities

In good economic times, it can often be difficult to obtain a small business loan. But, when times are tough, it becomes nearly impossible to convince a bank to take a risk on a small to mid-sized business. This puts the business owner in a tight position because he needs money to grow and make improvements if he is going to succeed. Innovations in small business financing on the Internet have opened up a whole world of possibilities for small to mid-sized business owners.

The latest trend is invoice financing marketplaces that offer services similar to accounts receivable factoring. For the business who is interested in accessing cash that is owed to them, here are the basics of this small business financing process and some key words to know:

The Basic Process:

A small to mid-size business owner needs cash now for growth, an improvement or even to make payroll. He has outstanding invoices where clients owe him money. He won’t see the money for a month or two, sometimes even longer. This is capital that is inaccessible to him at the moment.

So, he lists the invoices on an online auction site where an buyer purchases the invoice. For a fee, the business owner can access the working capital and use it to help his business grow. The buyer diversifies his investment portfolio with this low-risk, short-term financing opportunity and makes some money.

Words to Know

Invoice Financing versus Factoring- While the two are similar, the financing option gives more power to the seller whereas factoring allows the buyer to hold most of the cards.

In the marketplace for this form of small business financing, accounts receivable are posted at the discretion of the seller who also gets to set the minimum advance price and maximum discount fee. It is not a loan, but allows businesses to access money owed to them before the invoice due date.

Debtor – This is the customer who owes money to the business.

Accounts Receivable Invoice- This is the record of money owed to the business and what is posted on the auction site for purchase.

Buyers – This is the entity that purchases the accounts receivable invoice. The typical receivables buyer consists of banks, hedge-funds and other large financial and investment entities.

Advance – Prior to the completion of the transaction, the buyer agrees to a certain amount of cash advanced to the business. The amount may lean a seller towards one buyer over another. Once the debtor has paid the invoice in full, the seller receives the rest of the cash minus the fees.

Auction Closing Date – The seller can set the length of the auction process.

Asset-based Financing – This is a way for small businesses to access capital through the assets or collateral of the business. In this case, the asset is the outstanding invoice and it is a creative alternative to conventional bank loans.

Discount Fee – This is the amount determined by the auction that the seller pays the buyer upon sell of the invoice. It is basically how the investor makes his money. The seller can place a maximum value that he is willing to pay.

Buyout Price – Similar to eBay’s Buy It Now feature, Sellers can set a favorable price for which he’s willing to sell the invoice and end the auction before the specified close date.

A simple application to the online auction site can put a small to mid-sized business on the road to success with this innovative small business financing process.

The Small Business Interest Rate Trap

Many owners and managers struggle to get the small business financing necessary to operate and grow.

And while most people would universally agree that lower cost debt is better than higher cost debt, both end up having their place and purpose.

Low cost debt financing is reserved for low risk applications.

As the risk goes up, so does the cost of borrowing.

Pretty basic, right?

There is a twist however.

Most of the lower cost capital available for small business financing is based on personal net worth, personal credit, and income sources outside of the business.

So even though a business application of financing could be considered high risk, the business owner or manager may still be able to secure low interest rates based on their personal assets and income.

This creates the illusion that low interest rates are available for all small business applications, regardless of their size and relative risk.

Here’s where the trap comes in.

As the business grows, it will use up all the low cost financing leveraged from personal assets and will need to factor in higher cost small business financing sources to fund the capital requirements of the business.

At this point, the risk of the underlying business now starts to get reflected in the interest rates.

The problem is that hardly anyone ever plans for this to happen and the business leap frogs from low interest rate personal loans disguised as business loans into high interest rate personal credit cards.

If the business achieves short term profitability, there can still be low and medium range interest rate products available to fund growth.

But if the business startup period drags on, which is not at all uncommon, higher cost personal financing can quickly become the only capital available to cover short term losses and/or larger than expected start up costs.

To avoid falling into the low interest rate trap, consider the following steps when constructing your small business financing strategy.

>>> Be Ultra Conservative When Estimating Your Capital Requirements.

When you’re trying to start up a business, its all about being optimistic and getting things going so that you can make all kinds of money. Right?

In the excitement of planning a new venture its easy to delude yourself as to what the business start up is realistically going to cost to get going and become profitable.

A better approach is to be conservative with your small business financing requirements, factoring in all probable costs in more detail to increase accuracy.

Even if you think you’re being ultra conservative with your capital estimates, add another 20% to whatever number you come up with as a contingency fund.

Things can and will go wrong.

The perfect startup scenario is about the same odds as winning a lottery ticket, so you might as well go play your lucky numbers instead of banking on an overly aggressive small business financing plan.

>>> Understand The Limits and Criteria For Low Interest Rate Financing.

For startups, low interest rate financing comes from personal credit and government sponsored programs.

In either case, there are limits as to how much capital you can acquire.

The limits for government programs are normally well defined. Just don’t automatically assume that you qualify for the maximum amount.

Personal limits are going to be based on a combination of your credit score, your liquidat-ible personal assets, and the cash flow available to service the debt.

Short term profitability in the business will provide you with greater access to small business financing, but at a slightly higher interest rate compared to low cost personal financing.

The interest cost of incremental capital will continue to rise if the additional debt is not matched by corresponding amount of personal or business equity.

>>> Factor In The True Cost Of Borrowing

When creating your small business financing projections, make sure that you accurately estimate your cost of borrowed capital.

If your low cost money sources are not sufficient to cover off your capital requirements, then factor in higher cost sources available to you and see if the cash flow projections still work.

There is no value in creating an unrealistic cash flow projection.

It can only lead to poor business decisions which will not keep you in business very long.

If the cash flow numbers don’t add up, avoid the temptation to reduce your capital requirements or lower the average cost of capital just to make the numbers work.

The reality of good numbers may tell you not to proceed with your plans, which could very well be the best business decision you ever make.