Software development companies can be very profitable businesses but are also cash-flow intensive. This challenge must be managed correctly to avoid cash flow problems that could affect the viability of the business. This article discusses two techniques to address this issue. We cover:
- Revenues vs. costs
- Discounts for early payments
- Financing invoices
- Common invoicing problems
- Advantages of invoice factoring
- Limitations of factoring
- Qualification criteria
- Is factoring right for you?
1. Revenues vs. costs
Software companies often work on consulting and development projects for their clients. These projects can be an excellent opportunity for growth and a reliable source of revenue. However, they can also be a source of cash flow problems.
Many software projects are billed at their completion or in stages, depending on the scope. Customers don’t pay their invoices immediately. Instead, they ask for net-30 terms. Having net-30 accounts can be a challenge because most of your expenses are due before that.
Let’s take payroll as an example. Payroll is your largest expense and must be paid every two weeks. However, your customer may not have been invoiced for that work yet. Even if they had been invoiced, it would be due in 30 to 60 days. Your only option is to pay salaries and other expenses out of your cash reserves. You can replenish reserves and book the profit once the customer pays their invoice.
This situation won’t be a problem as long as your company has enough cash reserves to cover expenses. However, companies with small reserves could be at risk of cash flow problems.
2. Discount for early payments
Companies with minor issues can improve their cash flow by offering clients a discount if they pay early. This strategy is typical in the industry and can work well. It involves giving your client a 2% discount (negotiable) if they pay their invoices in less than ten days. Otherwise, the customer can pay the total amount on their usual terms.
It’s best to give this discount only to your best clients. These clients are those who reliably pay on terms. They are also the most likely to take advantage of it. Don’t make the mistake of offering early payment discounts to clients with bad payment histories. The discount seldom improves their payment track record and can backfire.
An early payment discount is an optional client incentive. Customers can take or decline discounts based on their cash flow situation. Furthermore, customers often stop taking advantage of this benefit when the economy goes through a recession. Take these limitations into consideration if you decide to use early payment discounts.
3. Invoice financing
Software development companies that need reliable cash flow should consider financing their invoices using factoring. This solution improves your cash flow and provides funds to cover business expenses and investments. To learn more, read “What is Invoice Factoring?”
a) How does it work?
Factoring transactions are structured as invoice purchases rather than loans. This structure has advantages because it simplifies the qualification requirements and allows for expedited deployment.
Most factoring companies buy your invoices in two instalments. The initial instalment covers 85% of the invoice and is deposited into your bank account shortly after you submit it. The second instalment covers the remaining 15%, less any fees. This instalment is deposited into your bank when your client pays the invoice. To learn more, read “How Does Factoring Work?”
4. Common invoicing challenges
Four common situations in the software development industry could affect your ability to factor invoices. In most cases, these invoices can’t be financed.
a) Customer issues
Customers may hold off paying an invoice if they discover an issue with the deliverable. Unfortunately, some customers abuse these situations and may exaggerate issues as a way to get additional (i.e., out-of-scope) work. This issue can affect the financing process since factoring companies consider it a customer dispute.
A way to minimize this problem is to have customers review your work and sign off on an acceptance report. This step can be part of the quality assurance process and helps ensure that your client is satisfied with your services. It has the added benefit of making the factor’s invoice verification process flow faster, which enables the finance company to pay you quickly.
b) Progress billing
Progress billing allows the software development company to send an invoice when a milestone is reached. This type of invoicing may also be referred to as milestone-based invoicing. Unfortunately, most milestone-based invoices cannot be factored. These invoices tend to have high levels of disputes and end-customer issues. Some customers may dispute that the completed product meets their specifications and may hold off on paying all invoices.
c) Factoring an invoice before delivery
Invoices can be financed only after the customer has received and accepted the work. Unfortunately, pre-billed invoices for work that has not been delivered are not at a stage where they can be financed.
d) Net-90 invoices
Some software development consulting projects can be long-term engagements. At times, the software development company may invoice customers with terms exceeding net-90 days. Most factoring companies won’t be able to finance these invoices. The financing cost to the client would be too high, and these invoices cannot be credit-insured.
5. Advantages of factoring
A factoring line offers several benefits for software companies over conventional lines of credit and similar solutions. The top five advantages are as follows:
a) Solves cash flow problems
Factoring is designed to solve cash flow problems from slow-paying clients quickly and effectively. This primary advantage of factoring is the reason that most companies get it.
b) Allows you to offer net-30 terms
Factoring allows you to offer net-30 terms to your clients while minimizing cash flow problems.
c) Adaptive line
Factoring lines are designed to adapt to your business. The lines can increase as your billable work from creditworthy customers increases.
d) Available to small companies
Factoring lines have simplified qualification requirements and are available to small and midsize software development companies.
e) Quick deployment
Factoring lines can be deployed quickly, often in days. The lines can be used by companies that have an immediate need for funds.
Factoring lines have two limitations you should be aware of. Consider all benefits and limitations before making a decision to use financing.
a) Solves one problem only
Accounts receivable factoring lines solve only cash flow problems due to slow-paying clients. It won’t help if your company has cash flow issues due to profitability, low sales, or other problems.
Factoring lines are more expensive than lines of credit of comparable size. These lines should be used only by software development companies with high profit margins. A minimum profit margin of 20% is recommended, though higher is better.
7. Qualification criteria
One of the main advantages of accounts receivable factoring is its simple due diligence criteria. Here are the most important qualification requirements:
a) Creditworthy customers
b) No encumbrances
Your invoices cannot be pledged as collateral for a loan or similar product. They must not have a lien or hypothèque against them.
c) No immediate risk of bankruptcy
Factoring lines can be used by companies with financial problems that need to be turned around. However, the company cannot be at risk of immediate bankruptcy.
8. Is factoring right for your company?
Factoring may be the right solution if the following are true for your company. Consult a financial professional (e.g., an accountant) if you are unsure about solving your cash flow problems.
- Cash flow problems due to slow-paying customers
- Creditworthy customers
- High profit margins (above 20%)
- No liens/hypothèques
- No risk of immediate insolvency
Get more information
We are a leading factoring company and can provide software development firms with competitive terms. For more information, get an online quote or call us toll-free at (877) 300 3258.