How Startups Can Use Factoring To Generate Cash FlowApr 19, 2023
Let’s say you’re a founder selling a physical product that requires you to manufacture something. And let’s say that manufacturing something means that you have to pay a percentage of the cost of your inventory upfront. If you have a long lead-time product that ships from overseas, it can be many, many months before you have revenue associated with that inventory (unless you presell it and you can read about that here!)
This is one of many possible scenarios that might call for factoring, but you’re yawning, I’m yawning and there’s really no way for me to make this exciting for either of us. So I’m going to simplify things.
The few who will find this fun and exciting are founders who need some cash flow and don’t qualify for, or don’t want to take out a loan or use another method to fund their business.
Factoring is a boring, but useful, financial tool used by businesses to convert their accounts receivable into immediate cash by selling their invoices to a third party (called a factor). This can be particularly useful for startups looking to improve their cash flow. There are several types of factoring that startups can consider:
- Recourse Factoring: In this type of factoring, you agree to buy back any uncollected invoices from the factor. This means you are responsible for any credit risk associated with your debtor's non-payment. As a result, recourse factoring is typically less expensive than non-recourse factoring.
- Non-recourse Factoring: In non-recourse factoring, the factor assumes the credit risk associated with the debtor's non-payment. This means that you are not obligated to buy back uncollected invoices. While this provides added protection for you, it usually comes with higher fees.
- Spot Factoring: Also known as single invoice factoring, spot factoring allows businesses to factor individual invoices on an as-needed basis. This provides flexibility but can be more expensive than other factoring arrangements due to the lack of an ongoing relationship with the factor.
- Invoice Discounting: Similar to factoring, invoice discounting involves selling accounts receivable to a third party. However, in this case, you remain responsible for collecting payments from debtors. This arrangement can be more discreet, as customers may not be aware of the involvement of a third party.
- Contract Factoring: This type of factoring involves a long-term commitment between you and the factor. In this case, you agree to sell all or a large portion of their invoices to the factor, typically for a lower fee compared to spot factoring.
- Reverse Factoring: Also known as supply chain finance, reverse factoring is initiated by the buyer (you), rather than the supplier. The buyer works with a factor to pay suppliers early in exchange for a discount on the invoice.
- Export Factoring: For startups involved in international trade, export factoring can be a useful way to manage cash flow. Export factoring involves selling foreign accounts receivable to a factor, who then takes on the responsibility of collecting payments from international debtors.
Each type of factoring comes with its unique advantages and disadvantages, so startups should carefully consider their specific needs, cash flow situation, and the creditworthiness of their customers before choosing a factoring arrangement.
Your factor will definitely be considering the creditworthiness of your customers when billing you!
And yes, there are other types of factoring that you can use to generate cash flow, but there’s only so much factor-speak that one can take in one blog. Consider this my PSA for April :)