One of the advantages of invoice factoring is that most transactions are not structured as loans. Instead, the client sells their accounts receivable to the factoring company in exchange for an immediate payment. This article describes how a company sells their invoices to a factor and covers the following:
- Factoring basics
- What is the client selling?
- Setting up a factoring account
- How are invoices sold?
Invoice factoring is a form of business financing that helps companies with cash flow problems. It works by financing invoices in two installments. The first installment covers 70% to 90% of the invoice and is deposited in your bank account soon after submitting the invoice to the factor. The second installment covers the remaining 10% to 30%, less the cost of the service. It is deposited to your account once your end customer pays the invoice in full.
Unlike conventional loans, invoice factoring is easy to obtain by small business owners. This is because factoring plans are not underwritten like loans. Instead, they are underwritten as the sale of receivables. This important difference enables factoring companies to offer financing to small companies with creditworthy commercial clients.
How are invoices sold to a factoring company?
Your business can sell an invoice to a factoring company only when you have fully delivered to the client all the services/products associated with that invoice. At this point, your responsibilities to the client have been fulfilled and your client must now pay the invoice in your agreed 30- to 60-day terms.
When a client sells an invoice to a factor, they are actually selling the financial rights associated with that invoice. Your company is selling the payment that is due to come from your client in 30 to 60 days. That factor buys the receivable and pays for it immediately. Since the factor has paid you for the invoice, they now “own” the payment that arrives later on.
Two types of factoring sales
Companies have two ways to sell an invoice to a factoring company: recourse and non-recourse. The legal details of each option can be complex, but “recourse” basically deals with what happens if your client does not pay an invoice.
a) Full recourse factoring
When a factoring company buys an invoice with “full recourse,” they have the option to sell the invoice back to you if your customer does not pay it. Many factoring contracts stipulate a recourse period of 90 days, though this time period varies by factoring company.
b) Non-recourse factoring
Non-recourse factoring can be more challenging to define since factoring companies usually offer their own version of the plan. In most cases, when a factor buys an invoice with no recourse, they won’t return the invoice if the end customer doesn’t pay due to a formal bankruptcy. However, the factor can sell the invoice back to the client if the end customer does not pay for other reasons.
Note that non-recourse factoring does not protect clients against customer disputes. Disputed invoices can be sold back to the client since disputes are considered a commercial matter between the client and their customer.
c) Which option is better?
There is no easy answer. Most factoring companies review the commercial credit of your customers carefully. This review allows them to detect potential insolvency risks ahead of time. Factoring companies avoid buying these types of invoices due to the risk of non-payment.
However, non-recourse factoring does offer good protection against surprise bankruptcies. However, these plans can also be more expensive due to the additional risk.
How to set up a factoring account
Before selling your accounts receivable to a factoring company, you first have to set up an account with them. Most factoring companies can set up an account in a few days. Once you have selected a factoring company, you can start the process of setting up an account.
1. Submitting an application
The first step in setting up a factoring account is to apply for financing. Each factor has its own application process, but most factors ask for the same set of documents. Once the factor receives your application, they perform their due diligence. You can find more information about the application process by reading our factoring application tips.
2. Due diligence
Factoring companies perform some basic due diligence before buying your invoices. Basically, the factor needs to determine if your company can sell its receivables and whether your clients have good commercial credit. This process is quick and is completed soon after the factor gets all the needed materials.
3. Contract agreement (purchase and sale)
The last step in setting up an account is to review and execute the factoring contract. In most cases, the contract is structured like an ongoing purchase and sale agreement. Read the contract carefully and review it with a lawyer. Contracts include critical information such as recourse type, rates, terms, and so on.
How to sell invoices to the factor
With an account in place, the factoring company is ready to buy your invoices. The process is fairly simple and can usually be done quickly.
1. Send a Notice of Assignment (one time per end-customer)
The factoring company needs to send a Notice of Assignment (NOA) to every customer you want to factor. This document advises your end customer that the receivables have been sold. Every factoring company uses a Notice of Assignment. The NOA is sent only once at the start of the factoring relationship.
2. Submit invoices
Submitting invoices is simple and can be done online or via email. In most cases, a Schedule of Accounts document accompanies the invoices. Clients use this document to list the invoices they are selling to the factoring company. You can use this process every time you need to sell invoices to the factoring company.
3. Verification and funding
Factors verify invoices before buying them. Once the invoices have been verified, the factoring company deposits the advance in your bank account. This process helps ensure that the invoice amount is correct and that it is still due from the end customer.
Get a factoring quote
We are a leading accounts receivable factoring company and can provide you with high advances at low rates. For more information, call us at (877) 300 3258 or get an online factoring quote.
Note: This article is provided for information purposes only and is not intended as financial or legal advice.