How to Manage Unpaid Invoices with Invoice Factoring for Small Business

If you’re managing a small business, you’ve likely faced cash flow disruptions at some point. These disruptions can negatively impact your business as you try to maintain your everyday business operations. One solution businesses use to avoid cash flow pitfalls is invoice factoring.

This article provides a comprehensive overview of invoice factoring, focusing how it helps small businesses with overseas customers. We’ll look at its benefits, costs, and alternatives to help business owners decide whether it’s the right solution for their cash flow needs. You'll also learn about Wise Business, an international business account for companies looking to send and receive money internationally at low cost.

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What is Invoice Factoring?

Invoice factoring is a financial transaction where a business sells its accounts receivable, also known as invoices, to a third party, known as a “factor,” at a discount. Essentially, the business is selling the right to collect payment on those invoices in exchange for immediate funds. That way, it gains quick access to working capital, rather than having to wait for customers to pay according to their agreed-upon terms.

There are several different types of invoice factoring available:

Type of Factoring	Description
Recourse Factoring	In the most common scenario, the business becomes responsible for repurchasing any invoices the factor isn’t able to collect due to customer default or bankruptcy.
Non-Recourse Factoring	In this scenario, the factor assumes the risk of non-payment due to customer insolvency, rather than the business itself. Due to the increased risk for the factor, this type is usually more expensive than recourse factoring.
Spot Factoring	Also known as single invoice factoring, this approach allows businesses to factor individual invoices on demand instead of committing to a long-term factoring agreement.
Full Factoring	As its name suggests, in this scenario, the factor takes full responsibility for managing accounts receivable and pursuing collections.
Notification Factoring	Customers are notified that their invoices have been sold to the factor and must address their payments to that factor.
Confidential Factoring	Customers aren’t aware of the factoring arrangement, so the business continues to manage collections while receiving funding from the factor.

Depending on your situation, you may find some types of invoice factoring more suitable than others. Ultimately, you’ll want to consider elements like industry expertise, fees and rates, and contract terms before deciding on a particular provider.

Invoice Factoring vs Invoice Financing: What’s the Difference?

First, let’s make sure we understand what invoice factoring is and isn’t. This financing option is frequently confused with invoice financing—a common mistake given their similar-sounding names. While both financing options are designed to provide funding based on invoices, ultimately, they take different approaches to the collections process.

Invoice factoring refers to the process of selling invoices to the factor, who usually takes on the responsibility of collecting payments from customers.

Meanwhile, invoice financing uses invoices as collateral for a loan. In this circumstance, the business retains ownership of the invoices and continues to manage the collection process.

Invoice financing is considered to be a better fit for businesses that want to maintain more control over their customer relationships and the collection process. However, if your business prefers to outsource collections, invoice factoring might be more suitable for you.

How Does Small Business Invoice Factoring Work?

Now that we know what invoice factoring is, let’s take a closer look at how it works in practice.

Generally speaking, recourse factoring is the most common approach pursued by businesses and factoring companies. Its fees are usually less expensive compared to non-recourse factoring since the factors assume less risk in this scenario.

Ultimately, specific procedures will vary depending on the terms of your agreement. Below is an overview of what businesses can expect in most factoring scenarios:

Step	Description
Issuing the Invoice	The business provides goods or services to its customers and issues an invoice with specific payment terms.
Selecting the Factor	When faced with cash flow issues, the business chooses the best factoring company for their needs.
Entering the Agreement	Before entering into an agreement, the factor evaluates the business’s customers by reviewing their creditworthiness and payment history.
Submitting the Invoices	The business submits eligible invoices to the factor based on specific criteria laid out in the agreement.
Advance Payment	The factor advances a percentage of the invoice value to the business, which is known as the advance rate.
Notification of Assignment	Unless a confidential factoring agreement is arranged, the factor notifies the business’s customers of the agreement.
Payment Collection	The factor collects payments from the business’s customers.
Final Payment	As customers pay their invoices, the factor releases the remaining reserves to the business, minus the cost of their factoring fee.

The qualifications for invoice factoring tend to be less strict than what you’ll find with more traditional loans, so they’re an especially attractive financing option for small businesses with limited credit history looking to meet short-term financial obligations.

Next, let’s take a closer look at what it takes to qualify for an invoice factoring agreement to see whether it’s a suitable route for your business’s cash flow needs.

Is Invoice Factoring Regulated?

In the United States, invoice factoring is regulated at the state level—resulting in a diverse regulatory landscape. Some states see factoring as lending, requiring financial licensing in contrast to other states that have minimal restrictions.¹

Factoring invoices internationally—such as in Canada or Europe—requires strict regulatory compliance. Not all U.S.-based factoring companies are equipped to handle cross-border transactions due to legal, financial, and operational complexities. If your business serves international customers, ensure your factoring provider is authorized and compliant in those jurisdictions before proceeding.

How to Qualify for Invoice Factoring as a Small Business

Before entering into an agreement, invoice factoring companies assess key aspects of your business model to determine if you’re a good fit.

Unlike traditional lenders, factors prioritize the creditworthiness of your customers over your business’s financial history. Most factors will start by looking into your customer’s payment history. If your customers have a strong track record of paying on time, you’re more likely to be approved.

Factors will also evaluate the quality of your invoices, including their accuracy, completeness, and compliance with industry standards. Be sure to have a strong sense of the common types of invoices and their standard requirements before seeking an invoice factoring agreement.

Naturally, factors will want to set themselves up for financial success in the agreement. Some will require minimum monthly or annual invoice volumes to ensure the arrangement is worth their while. Others may take your industry into account when setting up the agreement. Some industries are considered riskier than others, so businesses operating in those fields may face higher fees or stricter qualification requirements.

While business history isn’t as important as customer creditworthiness, it may still play a role in the approval process. Some factors may require personal guarantees from the business owner, especially if you’re a startup or a business with a limited credit history.

How to Choose the Best Invoice Factoring Provider

Of course, qualifying for a factoring agreement is only the first step. From there, you’ll want to do your due diligence on invoice factoring companies to ensure that you’re choosing the right provider for your needs. This process can make all the difference in facilitating a successful experience.

There are a couple of different considerations to keep in mind when choosing a factor for your small business. First, you’ll have to decide whether you prefer recourse or non-recourse factoring based on your risk tolerance and budget.

Additionally, it’s important to assess whether the factor has experience in your industry. Familiarity within the industry is key for grasping the unique challenges and typical payment patterns specific to your business. If you operate with international customers, you want to ensure the factor understands the nuanced aspects associated with international transactions.

Before signing the factoring agreement, it’s vital to carefully review everything. Pay attention to the terms and conditions, including the length of the agreement, termination clauses, and any restrictions on your business operations. Be sure to compare the fees and rates of different factors as well. It’s important to understand all the potential costs, including discount rates, advance rates, and any additional fees you’ll incur. Some factors may offer more competitive advance rates, which helps you maximize the amount of immediate funding you receive.

Finally, take time to research the factor’s reputation and track record. Read online reviews and check with industry associations to get a sense of their reliability and service quality. You’ll want a partner who’s responsive, helpful, and capable of delivering exceptional customer service to make the most of your relationship.

There are many reputable invoice factoring companies available to help your business manage outstanding invoices more effectively. Before committing to adopting this type of financing strategy, you’ll want to gain a deeper understanding of both its benefits and drawbacks to ensure it’s the right fit for your business.

Pros and Cons of Invoice Factoring

As we’ve seen, factoring invoices can be a valuable tool for small businesses seeking to improve cash flow, especially when dealing with delayed payments from overseas customers. However, it’s not a one-size-fits-all solution. Even if you qualify, you’ll want to carefully consider the following pros and cons before moving forward with an agreement.

Pros	Cons
Improved Cash Flow: Invoice factoring provides immediate access to working capital to help businesses cover funding gaps caused by slow-paying customers.	Invoice Factoring Cost: Factoring invoices can be expensive, and it reduces the profit you’ll bring in from each invoice.
Easier Qualification: Since factors prioritize the value of your invoices and the creditworthiness of your customers, qualifying is typically easier compared to traditional loans.	Loss of Control: If the factor works directly with your customers, there needs to be trust to handle the relationship responsibly.
No Collateral Required: Businesses are not usually required to put up additional collateral like real estate or inventory.	Potential Liability: You may be responsible for unpaid invoices if your customers default.
Outsourced Collections: Some factors handle invoice collections, therefore, reducing the administrative workload for your company.	Customer Creditworthiness: If your customers’ ratings aren’t satisfactory, you may not be able to qualify for factoring.

The Benefits of Factoring Invoices

Let’s start with the benefits. Invoice factoring has become a popular financing option among small and medium-sized businesses due to its flexibility and accessibility. One of its biggest advantage is fast access to working capital, allowing businesses to meet their financial obligations, invest in growth, and seize new opportunities—all without waiting for customer payments to come through.

Since its qualification process is less strict than traditional loans, invoice factoring is seen as a more accessible financing option for small businesses. That’s especially true for companies without lengthy credit histories or large-scale collateral to put up for a more traditional business loan. If you aren’t able to qualify for lines of credit or other business loans, invoice factoring is always an option for you.

Also, this financing option is quite flexible compared to other options on the market. Since some invoice factoring companies allow the process to be scaled up or down as needed, businesses can adjust their participation per their fluctuating cash flow needs.

Finally, businesses with limited resources may benefit from the reduced administrative burden associated with invoice factoring. By outsourcing time-consuming accounts receivable tasks, teams are freed to focus their attention on their core operations and optimize their contributions to the company.

Of course, this isn’t without its risks. Putting collections in the hands of the factoring company means trusting an outside party to handle your valuable customer relationships. This is why it’s critical to do your due diligence before moving forward with a particular provider.

The Drawbacks of Factoring Invoices

As hinted at in the previous section, no financing method comes without its drawbacks. In the case of invoice factoring, these come at a cost—quite literally. Since factoring involves selling invoices at a discount, your business won’t receive the full face value of the invoice, even when the customer makes their final payment.

The factor fee—also known as the discount rate—is the primary cost of factoring. It’s usually a percentage of the invoice value, which can range from 1% to 5% per month depending on various considerations like the industry, invoice volume, and customer creditworthiness.²

Some factors may also charge additional fees, such as application fees, due diligence fees, or late payment fees. Be sure to carefully review the factoring agreement to understand all potential costs when determining whether this financing option makes sense for your business.

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Is Invoice Factoring The Right Choice For My Small Business?

Now that we have a clear understanding of invoice factoring, how it works, and how to qualify for a factoring agreement, it’s time to ask the question: is this the right financing option for my small business?

If you frequently struggle with cash flow gaps due to slow-paying customers, invoice factoring may be a sufficient way to address your business’s cash flow needs. However, before moving forward with an agreement, carefully evaluate whether this option aligns with your business goals and financial situation.

Start by conducting a thorough cost-benefit analysis. Consider whether your business can comfortably afford the factoring fees and discounts applied to your invoices. Conducting a cash flow analysis can optimize both inflows and outflows.

As a business, you will need to decide whether you’re willing to assume the risk of customer default in the event of recourse factoring. At this stage, you may find it useful to work with a qualified accountant or professional accounting software to save time and get expert insights into your business’s finances.

Decide if you’re comfortable with a factoring company contacting your customers directly. Some providers offer confidential factoring, though this practice is rare and likely to come at a higher cost. If you allow a factor to contact your customers directly, ensure they provide an exceptional customer experience that reflects positively on your brand.

Finally, take some time to explore alternative financing options, such as business loans or lines of credit, to determine if invoice factoring is the best solution for your needs.

6 Alternatives to Invoice Factoring for Small Business

To make an informed decision about whether invoice factoring is the right fit for your business, take a moment to compare its pros and cons with some other common financing options for small businesses. Depending on your situation, you may find some of these options more suitable for you.

#1 - Business Loans

Your business may be able to take advantage of traditional bank loans or Small Business Administration (SBA) loans to cover your cash flow needs. That said, you’ll face a more stringent qualification process when applying for these loans. Businesses typically need to prove a strong credit history and provide collateral throughout the lengthy application process.

#2 - Working Capital Loans

If you need more immediate access to cash, there are a variety of traditional and online providers available to provide working capital loans to small businesses. While you’ll still need to qualify, these providers offer faster approval and payment processes that address short-term cash flow disruptions.

#3 - Lines of Credit

With a line of credit, businesses gain access to a predetermined amount of funds, which can be drawn upon as needed. Unlike more traditional loans, interest is only charged on the amount withdrawn. It’s a flexible way to access short-term capital without putting a large financial strain on your business. However, like with business loans, you’ll likely be required to have good credit and collateral to qualify.

#4 - Invoice Discounting

Similar to invoice financing, invoice discounting for small businesses lets companies borrow against their invoices while retaining control over the collections process. The costs can be significant, but it’s usually easier to qualify when compared with more traditional loans. Plus, you’ll be able to manage your customer relationships yourself, since the process is designed to remain confidential.

#5 - Supply Chain Financing

With supply chain financing, businesses have the opportunity to connect with third-party financiers who can cover supplier costs ahead of time. It improves cash flow by allowing suppliers to receive payments earlier, while also enabling buyers to extend payment terms. That said, implementing SCF can be complex, and access is limited for smaller businesses and suppliers.

#6 - Customer Payment Solutions

A final option is reaching out directly to your customers to work out a more favorable payment schedule. You may be able to improve cash flow by offering incentives for early payment, like letting them pay in their own currency to avoid volatile exchange rates. It’s also worth reevaluating your payments terms to ensure they’re clear and explicit to discourage late payments. Implementing automated payment reminders can help encourage customers to engage in a more timely fashion.

The Bottom Line

Invoice factoring is a practical solution for small businesses seeking to unlock the value of their unpaid invoices and improve cash flow. When implemented strategically, it can set your company on the path to long-term financial success, providing the working capital you need to meet short-term obligations while waiting for customers to make payments.

This financing option is especially appealing for businesses with overseas suppliers and customers, who can face extra-long waits when receiving payments. If you find yourself struggling to get timely payments from overseas customers, learn how Wise Business can help you get paid faster. Set up local account details for your business in any of eight different currencies and get paid like a local today.

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Sources:

1. Regulation of Commercial Finance Companies is Here and Intensifying | IFA Commercial Factor
2. The Pros and Cons of Invoice Factoring for Business Owners | For Financial