Need a Cash Injection? Consider AR Financing

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Alternative Financing Options

In an ideal world, it would be super simple for every business to seek and receive financing whenever they’re in need of funds! But the financing landscape is a little more complex than that and often financing is based on industry, business history, credit scores, access to collateral, and a number of other factors that can limit a business’s access to financing. Thankfully the financing industry is starting to catch on to this need and more and more alternative financing options are becoming available across the US.

One such financing option is called accounts receivable (AR) financing or invoice factoring, which at its heart involves selling the outstanding invoices of a company to a finance/factoring company at a marked down rate in exchange for cash flow.

What is Invoice Factoring?

Your accounts receivable sit on your balance sheet under current assets making them one of your company’s liquid assets. If you read our past blog post, you’ll remember that liquid assets are those that can most easily be turned into cash. You can now begin to see why it makes sense to factor your AR for cash.

So we’ve touched on this briefly, but let’s really set the stage for what invoice factoring is. Accounts receivable (AR) financing or factoring is a type of financing where a business receives capital in exchange for a portion of their AR – we know this already from our introduction. But there are really two types or structures of AR financing. This financing method can be structured as an asset sale (invoices are sold to the financier) or a loan (invoices secure a cash advance that must be repaid).

Structure 1: The Asset SaleAR Financing or Invoice Factoring can be structured in two ways.

Generally, most AR financing falls into the asset sale category. In this structure, a company sells its AR in the form of an asset sale (as it is shown on the balance sheet) to the lender.  In return for the AR, the lender pays a portion of the total value of the AR to the company and the lender now owns and can collect on the outstanding debt.

For clarity’s sake, since the company no longer owns the outstanding invoices they can’t collect on them internally. This structure often has a level of recourse included in its contract, where the factoring company can request you pay them back on any uncollectible AR, including AR that has been hit with chargebacks.

Structure 2: A Loan

The second structure, and less used, is a loan. In this structure, the company receives capital from a lender using their AR as collateral for the loan. They continue to own the AR for the duration of the loan unless they default, in which case the lender can take ownership of the AR and collect on those debts as a repayment of their loan. In this structure, the company will also accrue interest on the loan at a prime rate or the factoring company will assess a predetermined upfront fee that is lumped into the loan amount – this is simply the cost of borrowing.

Why Factoring?

As we mentioned earlier, not every business is able to depend on traditional financing methods like SBA loans for their financing needs. Or they may not need such a large sum of money as would be offered in traditional financing routes. So AR financing or invoice factoring can be a great alternative to businesses who are looking for a quick, cash injection for business growth or as a stop-gap when experiencing cash flow issues. Let’s take a look at some of the advantages and disadvantages of this financing method so you can determine if it might be a fit for your capital needs.

The Advantages of Invoice Factoring

Quick & Easy. The process for applying to a traditional loan involves a lot of paperwork and a lot of time between application submission and the eventual approval/disapproval. With AR financing the turnaround time is much quicker and involves a lot less i dotting and t crossing on the back end. This means this is a much more suitable option when your business needs cash quickly.

Minimal Requirements. Since the outstanding invoices themselves are the collateral, there is no need to worry about signing away your family home or business equipment to pay off your debts. AND many of these lenders do not require a minimum credit score, which can be a big hurdle in the traditional loan process.

Business Ownership. Many businesses that are unable to get traditional debt financing, have to seek equity financing options and end up diluting their company ownership way before they were planning to do so. AR financing offers a great option for funding that doesn’t give away any owner equity.

As Needed Cash Injection. With traditional financing methods that provide a large lump sum of money, it would be unlikely to seek this type of loan multiple times in one year. But when working with a factoring company, there is the possibility to seek capital on an ongoing basis as your company’s needs change from month to month. In fact, many factoring companies love this, because they get to build a stronger relationship with you and you them.

The Disadvantages of Invoice FactoringAR financing contracts vary from lender to lender.

Fees. Since requirements like minimum credit scores are not part of the puzzle it makes sense that factoring companies charge higher fees for their services. Depending on whether you go for the asset sale or the loan structure, you will have to weigh if the fees and interest accrued make sense for your business, as opposed to waiting for the invoice to be settled in due time.

It is important to point out that it is a best practice not to factor AR for customers who pay on time, since this will allow you to avoid unnecessary fees. So if your business does not have a good number of aging accounts receivable this may not be the right financing option for you to begin with.

Contracts & Liabilities. Depending on the factoring company you work with, your finance needs, the state of your AR, and the structure of your agreement you can expect some variance between contracts. Though AR financing is often favored because of its limited or short-term contracts, not all companies operate the same. So be sure to fully understand what you’re signing up for before executing the agreement.

Terms to be aware of can include recourse opportunities, where there is the potential that you will be liable to pay an unpaid invoice or one that becomes uncollectible that your factoring company owns. For example, for CPG companies if an outstanding invoice gets hit with chargebacks or deductions from KeHE or UNFI it becomes uncollectible and you may have to reimburse your factoring company for that invoice.

Who is AR Financing a Good Fit For?

Of course, when it comes time to weigh the advantages and disadvantages of AR financing, this can become a very personal business decision. That being said AR financing can be a great fit for a number of use case scenarios including small businesses who need to cover a short-term gap in cash flow, those with seasonally fluctuating businesses, and those experiencing fast growth or expansion demands. 

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About Lorne Noble

Lorne loves finance so you don’t have to (seriously, he plays with Excel sheets on vacation)! He spent 12 years in corporate London as an investment analyst then made the jump to Boulder, Colorado to act as finance mentor to high impact companies at The Unreasonable Institute, Girl Effect Accelerator and Singularity University. He has an MBA from IE business school in Madrid, Spain.

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