Are your eyes starting to glaze over? We don’t blame you. Invoice factoring has been around for thousands of years, but it seems like the terms have only gotten more complicated.
What is a Factoring Agreement?
A factoring agreement is a financial contract that details the full costs and terms of purchasing a business’s outstanding invoices. When a business and a factoring company decide to start the invoice factoring process, they enter a factoring agreement. Generally, factoring agreements will cover the upfront costs of factoring, maintenance and termination fees, and legal consequences in the event a business is unable to pay back the purchased invoice from the factor.
Invoice factoring lets you get cash advances on unpaid invoices, making it a wise option for addressing cash flow gaps. To find the best invoice factoring company, it’s important to understand what your top cash flow concerns are.
Prioritizing your cash flow concerns will help weed out the hundreds of factoring companies to choose from. Asking yourself how much you’ll need, the type of service you want, and how often you plan on drawing should serve as a guide when looking for an invoice factoring company and understanding a factoring agreement.
Fees, Fees, and more Fees
Once you’ve identified how much your business is willing to allocate for factoring, start reading the fine print. Most business owners are primarily concerned with two issues: how much money will they receive upfront, and how much will they need to pay for the advance. Fees impact both of these, so here’s a rule of thumb: Pay attention to any fees beyond the weekly or monthly factoring fee. These are the top fees to pay attention to:
Origination/Draw fee: This is a flat percentage that the factor will take upfront on the facility amount. For example, if you have a $1MM facility with a 1% origination fee, $10,000 of fees will be taken out of initial funding. Termination fee: If at any point in time you decide to cancel your agreement, you may have to pay a termination fee. Termination fees are typically a percentage of your credit line. So, if you have a $100,000 credit line and a 5% termination fee, be ready to spend $5,000 to end your agreement. Termination fees can range from 3% to a whopping 15%, so be sure to read your agreement closely.
Monthly fees: It’s easy to forget maintenance or lockbox fees. But if you factor $10,000 in one month and have $200 in unrelated monthly fees, that’s the equivalent of paying an extra 2% on your invoices for that month! Some factors may even charge fees for ongoing due diligence.
Fees are what make it hard to compare the true invoice factoring cost among companies. If you find a rate that looks too good to be true, it probably is. Prioritize factors with no hidden fees. It’s also smarter to go with factors that charge weekly instead of monthly fees.
Here’s an illustration: You have two factors. One charges 0.5% a week, while the other charges 2.5% every 30 days. They may appear to offer similar pricing. But in factoring, a monthly fee means a customer gets charged the full discount fee for a partial period. Let’s say an invoice pays in 35 days. That’s roughly five weeks. With the factor charging a weekly fee, the total fees would be 5 x 0.5%, or 2.5%. With the factor with a 2.5% monthly fee, the total fees will be rounded to 2 (months) X 2.5% = 5%.
If you want to go deeper, read our breakdown of a real agreement from a traditional invoice factor.
Decoding Your Factoring Agreement Terms
Decoding legal agreements are never fun, but we’ve selected and translated the most important terms to help you understand your factoring agreement and what it may cost you:
Customer Limit: The limit on how much funding can be tied to any individual customer. For example, you may have a $100,000 credit line, but if you have a customer limit of $50,000 then you can’t use your entire credit line on invoices from a single customer.
Factoring Commissions: The fees you pay the invoice factor.
Minimum Annual/Sales Commission: The minimum amount you must pay the invoice factor over a term, usually per year. Watch out for this clause for it means that you may end up owing the invoice factor money even if you don’t use their services.
Reserves: Money held in escrow by the invoice factor. If a factoring company is holding money in reserve, your funds will be stuck with the invoice factor instead of your customers. This completely defeats the purpose of advancing invoices.
If you don’t clearly understand how everything works, that may be a sign that the invoice factor is hiding something in the legal language. If so, it might be time to look elsewhere to factor your invoices.
Want clear terms? Do your due diligence.
Modern, cloud-based lenders strive to make factoring as streamlined and transparent as possible, but it’s easy to fall prey to lenders who hide their fees and terms in their agreements. You can never do enough due diligence when looking for the right factoring company because it will save your business thousands of dollars down the line.
Bluevine offers speed, simplicity, and transparency in our factoring services. We have no hidden fees, termination fees, or other long-term lock-ins fees. You won’t have to worry about complicated legal language or commit your business for multiple years at a time. Simply factor the invoices you want, on your terms.
This article was first published on April 11, 2016. It was updated on Feb. 8, 2018.