Before you can understand the differences between the many types of invoice factoring, you have to have a good understanding of what factoring actually is.
Here’s an example:
Let’s say you won the lottery – a jackpot of 10 million dollars, to be received in increments of 200 thousand a year for the rest of your life. But, they may be the chance you may not live long enough to collect it all.
The state may offer you a lump sum of 4 million dollars, well shy of the 10 million you won.
But let’s stay a third-party entered the picture, and offered to pay you 6 million as a lump sum, as a way of buying the 10 million dollar debt you can’t wait around to collect.
That’s how factoring works.
Perhaps you have $10,000 in accounts receivable. It will pay out in 90 days. But you have a job to do right now, and that job requires you to invest thousands up front.
By taking your accounts to an invoice factor who will offer you a lump sum for the total of your invoices, you can have that money in hand as soon as the next day. That is the basic structure of invoice factoring.
And that’s just the beginning. Here’s everything you need to know about the various factoring services out there:
For the next level of understanding, here is the question you need to ask: What happens if the clients fail to pay their invoices?
Here is another way to think about it: What recourse does the factor have if your clients fail to pay their debts? That is what recourse factoring is all about.
Here is the answer in most situations: If your clients fail to pay their debts to the factor, then the recourse they have available is to come to you for the money. Factoring is not a good option if you strongly suspect your clients will default on their payments.
Factors do background checks on you and all your clients for which they hold invoices. They have a pretty good idea about the risk they are taking on. They generally will avoid high-risk invoices. But sometimes defaults happen. Just remember, in recourse factoring, you are the recourse if it comes to that.
On the surface, this brand of factoring sounds safer. After all, if the factor has you as a recourse in recourse factoring, then you surely have no liability with non-recourse factoring.
Unfortunately, that is not really what that means. There are few, truly liability-free factoring situations. The problem comes when you think you are liability free but learn differently at the least convenient time.
None-recourse factoring should probably be called limited recourse factoring. That’s because most of the time, there is recourse. It is all a matter of how the deal is structured.
A common structure is that you have no liability if the client files insolvency within a 30 to 90 day period. Outside of the specific exceptions, your liability is the same as with recourse factoring.
Don’t let the name of the factoring service fool you. It is all about the details of the contract. These are details you will want to read carefully. The details determine which type of factoring you should consider.
The Deciding Factor
Knowing this much about invoice factoring still does not tell you which type of invoice factoring is right for you. For that decision, you have to balance initial payout versus total risk.
Because there is less risk to the factor in recourse factoring, the payout is greater. In a situation where all the clients pay their debts in a timely manner, this is the best option for all parties concerned.
Because non-recourse factoring is slightly more risky to the factor, the payout to you is lower. However, you offset that lower payout against slightly lower liability.
The key is to never assume which type of factoring is the better deal before having a conversation with an invoice factoring service and going over the details.
Recourse and non-recourse are important words, but not the words on which a factoring decision can be made. As with any contract, it is all about the details.
Notification Vs. Non-notification Factoring
Do you want your clients to be notified that you have reassigned their debt? If so, you will want notification factoring. Communications about billing will come from the factor. The billing relationship will no longer be with you, but with the factor.
Non-notification factoring means that your clients will not be notified of the reassignment. Though the factor will still be handling all billing communication with the client, they will be doing so in your name, even to the point of introducing themselves as your company when phoning the client.
Spot Vs. Contract Factoring
How much of your accounts receivables would you like to place under factoring? Some companies will let you factor as little as a single account on a highly flexible basis. That is spot factoring.
There could be fees involved in you do not use it often enough via the terms of the agreement. But it is a fast, flexible, and easy way to turn a few accounts into cash.
Contract factoring is much less flexible as it requires the involvement of a minimum number of accounts, or all of your accounts receivables. This type of long-term relationship with a factoring service might be beneficial for contractors.
Other Terms to Know
Contra Account – This describes the type of account held by companies that are both customer and supplier. These accounts are challenging.
Debtor Financing – This is a mostly Australian term for factoring.
Export Debt – This is money owed to a client by the customer overseas.
Rebate – Factoring is paid out in two parts. There is the initial amount to get you started. The rest is paid when the rest of the money is collected. That agreed upon portion minus applicable fees is the rebate.
If we have made this sound like mindlessly easy money, we apologize! The process is not difficult. But it is a serious financial transaction that must be entered with care.
There is always more to learn. But knowing the difference between recourse, non-recourse, notification, non-notification, spot, and contract factoring should get you pointed in the right direction.
Did you have other questions about factoring services? Let us know!