Invoice Factoring: A Quick Guide on Factoring Contracts

factoring contracts

As a small business owner, there will come a time when you’ll need additional working capital to drive your business forward. There are several options to secure financing, but if your business processes a significant number of invoices, you might want to consider invoice factoring.

What is Invoice Factoring?

Invoice factoring is a financing option that allows you to sell outstanding invoices in exchange for upfront funding. This means you don’t have to wait for 30, 60, or even 90 days to receive payment from the services you rendered. Lenders can give you up to 90% of the total invoice value based on the strength of your invoices and the creditworthiness of your customers. Invoice factoring bridges cash flow gaps, allowing business owners to pay for day-to-day, payroll, and other business expenses.

What is a Factoring Contract?

A factoring contract outlines everything you need to know when lenders purchase your outstanding invoices. So, if you decide to factor your invoices with a factoring company, you enter into a factoring agreement. A factoring contract generally details the upfront costs of the factoring transaction, fees, and legal consequences if a business defaults on payments.

However, it’s important to find the best invoice factoring company to work with and understand your current financial situation. Evaluate your business and determine how much money you’ll need, how often you plan to withdraw money, and more. Knowing what you need will help you look for a factoring company that best suits your objectives.

Terms in a Factoring Contract You Should Know About

Keep in mind that the terms factoring contract use vary depending on the factoring company you’re working with. However, here are some of the most common terms they use:

However, it’s important to find the best invoice factoring company to work with and understand your current financial situation. Evaluate your business and determine how much money you’ll need, how often you plan to withdraw money, and more. Knowing what you need will help you look for a factoring company that best suits your objectives.

Selling Accounts Receivable

A factoring contract will cover the invoices you’re going to sell to the factoring company. If you’re not going to factor (aka sell) all pending invoices, make sure to discuss that with the company you’re working with.

Customer Limit

This pertains to the limit on how much financing is tied to each customer. For example, you qualified for a $200,000 credit line, but your customer limit is $100,000. This means you can’t use your entire credit line from one customer.

Approving Credit

Unlike traditional financing options, approval for invoice factoring is primarily based on your customers’ creditworthiness rather than yours. Factoring companies will check your customers’ credit rating, so when you sign a factoring contract, you’re consenting to let the factoring company run credit checks on your customers.

You need to inform your customers, and you also need to know what will happen if they refuse to comply. Ask the factoring company how long will they give you to talk to your customer before they drop your account.

This isn’t usually a problem for most businesses, but you want to prepare everything before signing an agreement.

Advance Amount

This is the most important aspect of a factoring contract because this pertains to the percentage of the invoice you get upfront or the amount of money you receive. The advance amount varies depending on several factors, like invoice amount, customer creditworthiness, location, industry, and more.

Termination Provisions

Factoring agreements often outline the length of a factoring relationship. You can terminate your agreement, but the factoring contract indicates how far advance you can do so, usually between 30 and 90 days. For instance, you have an initial term of six months, but you don’t want to work with this factoring company after your term ends. Based on the factoring contract, you’ll need to inform the factoring company 30 days before the term ends that you’re not renewing the agreement.

Most Common Invoice Factoring Fees Outlined in the Contract

Most borrowers are only concerned with two things:

  • How much money they’ll get upfront; and
  • How much does the entire transaction costs

Take note of the fees other than the weekly or monthly factoring fee. Keep in mind that these fees vary lender by lender, so make sure to compare your options.

Here’s a list of the most common invoice factoring fees that may be included in factoring contracts:

Factor Fees

This refers to the fixed percentage factors take from your advance amount. For instance, if you qualify for $1,000,000 upfront with a 1% factor fee, the factoring company will take $10,000 upfront.

Termination Fees

If you decide to terminate your contract, some lenders may charge a termination fee, usually a percentage of your credit line. This means if you have a $100,000 credit line and the termination fee is 5%, you’ll need to pay $5,000 to the factoring company. Termination fees range from 3% to 15%, so make sure to review your factoring contract closely.

Credit Check Fees

As mentioned, lenders perform background research on your business and your customers to gauge the risk they will take. However, they may charge a fee for background credit checks. You may also get charged a credit check fee if questions about your customers’ credit rating may prompt a credit check. This protects factoring companies from businesses with unreliable customers.

Monthly Fees

Other monthly fees may include maintenance fees, lockbox fees, and ongoing due diligence fees. You need to know the fees you’re going to pay because some borrowers pay an extra 2% to 5% for additional fees.

When comparing invoice factoring options, be sure to compute the monthly or weekly fees accurately. If you think that the rates look too good to be true, it probably is. Choose factors that don’t charge hidden fees.

Things to Consider When Reviewing Factoring Contracts

When reading a financial contract, it’s best to seek advice from a small business attorney. It’s important that you understand how the contract impacts your business. Here are some of the things you need to consider when reviewing factoring contracts.

Be Sure to Read the Full Contract

This may seem like a no-brainer, but some applicants only skim rather than read the entire contract. Every penny matters, so it’s crucial that you read and understand the entire contract from the onset. Unforeseen fees and expenses that you may have missed will cost you in the long run. Review the contract yourself, with a partner and a lawyer to ensure that you have everything covered.

Factoring Companies Represent of Your Business

When you sell your invoices, the factoring company will be the one to collect the payments from your customers. The factor you’re working with will have direct contact with your customers involved in the factoring transaction. This means that your customer will know that you factored their invoices.

How the factoring company handles payment collections will directly affect your small business. Before you commit, understand how factors collect payments to ensure that your customers stay happy and satisfied despite the changes in management.

Know Your Responsibilities

As mentioned, factoring contracts outline the weekly or monthly payments you need to make. Otherwise, penalty fees may apply. If you’re not comfortable with the arrangement, you can negotiate your factoring contract or consult with another factoring company.

The Bottom Line

Invoice factoring is a great way to leverage your pending invoices to bridge gaps in cash flow. It also frees up more time for your employees since the factoring company collects customer payments.Remember that different factoring companies have different terms in a factoring contract, so do your research and compare offers from several lenders. This ensures that your business is getting the most out of your factoring contract to support your company’s growth.If you don’t understand how everything works, there’s a chance that the factor is hiding something using legal jargon. If this is the case, it’s best to look for another factoring company.

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