The biggest expense for most software companies is payroll. Technology equipment is cheap compared to the salaries of software engineers who design, develop, test, and deploy the software. Few entrepreneurs plan for this expense when they start their companies. However, payroll expenses can often trigger cash flow problems for technology companies.
Unlike supplier payments, whose timing can be negotiated, salary must be paid regularly. And salary payments can’t be delayed without serious consequences to your company and its employees. But expenses are only part of the equation.
Payment terms and slow revenues
Most software development projects use progress billing, in which you develop a stage of the project and deliver it to your client, who then performs quality testing and pays you for it. However, they seldom pay immediately. Rather, most large corporations require payment terms – the option to pay an invoice in up to 60 days – as a condition of doing business; negotiating faster payments is often very difficult.
This condition means that your company must pay employees to develop software and then wait 30 to 60 days to get paid. Few software companies, especially small businesses, have the financial resources to wait for payments.
Conventional financing is tough to get
Most technology entrepreneurs have options to finance their businesses. They can use their own funds, ask friends to invest, or raise capital private investors. Some may be lucky enough to get venture capital financing – the “gold standard” for technology companies. However, most of these options are difficult to get and often require that you surrender equity in your company.
Another alternative is bank financing. However, many banks are not comfortable financing technology companies without reliable cash flows. Most banks try to determine if a combination of existing and future cash flows is sufficient to pay them back. Banks also have strong collateral conditions and require financial reports showing multiple years of profitability. This requirement can put bank financing out of the reach of small and mid-sized software development companies.
A better alternative? Factor your invoices
The financial problem is relatively simple: expenses need to be paid quickly but revenues flow in slowly. If clients paid quickly, you would not have a working capital problem. Fortunately, this problem is relatively easy to solve. Invoice factoring offers many of the benefits that you would ordinarily get from quick-paying clients.
Invoice factoring provides an advance on slow-paying receivables due from creditworthy commercial clients, giving your software company immediate funds to cover payroll and other expenses. The transaction settles when your customer pays their invoice on their regular schedule.
When used correctly, invoice factoring can improve your cash flow, but the greatest benefit is that you can offer payment terms to clients without negatively impacting in your cash flow.
How does invoice factoring work?
The transaction is relatively simple. Your software company partners with a factoring company who finances your invoices in two installments: the advance and the rebate. The advance covers about 80% of the value of your invoice and is wired to your bank account as soon as your project, or deliverable, is accepted by your client. The remaining 20%, less the fee, is rebated as soon as your client pays the invoice in full.
Use an acceptance letter for each stage
In general, software projects can be difficult to finance because of their duration, the fact that they are billed in progress stages, and because project stages have dependencies. Further complicating matters is the fact that clients often change requirements, or project scope, mid-project.
These problems can be minimized by using an acceptance letter that the customer signs at each delivery. The acceptance letter should be crafted by an attorney and cover which items have been delivered and tested by the client. An acceptance letter helps minimize the chances that clients withhold payments due to changes in scope that have not been previously agreed to.
Does my software development company qualify?
Since the factor is financing your invoices, it is important that your clients have good commercial credit. Also, your accounts receivable should not be encumbered by liens, and your company should not have serious tax or legal problems. Lastly, your billing practices must be compatible with this type of funding.
Gain a strategic advantage
Invoice factoring can offer a strategic advantage if your main financial issue is cash flow problems due to slow-paying customers. The financing line does not have a fixed limit; rather, the limit is determined by the quality of your customers and the value of your invoices, and it can increase with your revenues to support organic growth. This advantage makes invoice factoring an ideal alternative for small and growing software companies seeking funds to capitalize on growth opportunities.