Factoring can be a crucial component in growing your business. When a small business starts to expand, the company’s owners take on larger financial responsibilities at a faster rate.
In some cases, there can be a gap between what businesses want to provide and what their financial resources allows them to provide. Factoring can alleviate this financial burden while allowing businesses to continue to grow.
Before you can decide if factoring is right for you, it’s important to familiarize yourself with all that factoring agreements entail. So, let’s dive into the key elements that make up a factoring agreement!
How Does a Factoring Agreement Work?
A factoring agreement is a contract in which business owners sell their outstanding invoices in exchange for upfront capital. Factoring companies usually pay up to 98% of the invoice value to businesses and then follow up on the invoice to ensure it gets paid by the client. Once paid, they subtract a small service fee and return any leftover holdback to the business.
Since many invoices can take 30 to 90 days to process, factoring companies reduce the turnaround time by providing an advance on their clients’ receivables. This provides a flexible solution for small businesses to improve and maintain their cashflow.
What Are Common Fees in Factoring Agreements?
Most fees are usually clearly outlined within a factoring agreement. These rates can fluctuate depending on the provider, but here are some fees that you should look out for prior to signing off on a factoring agreement:
- Origination Fee: This is an upfront fee that your business will need to pay prior to the activation of the factoring agreement. This fee is usually around 1%, though you will receive this amount back via the funds that are obtained once the agreement starts. Some factors don’t charge an origination fee.
- Factoring Fees: These are the fees that you have to pay on the face value of your invoices. For monthly rates, these fees typically range anywhere from 1.15% to 3.5% on average.
- Funding Fees: Some factoring companies charge nominal fees for every invoice or batch that they process. These fees can either be a few basis points or a few dollars. Be careful, some factors aren’t up front about the existence of these fees and they can add up quick.
- Termination Fee: Termination fees can fluctuate from 3% to 15% of your overall credit facility, depending on the provider. This fee is only realized if your business decides to terminate the agreement prematurely.
- Limit: Factoring agreements have a limit on how much credit you can extend to your customers. For example, if you have a facility limit of $200,000 with a $100,000 customer limit, you will not be able to extend the entirety of your credit facility to just one customer.
What Are the Other Conditions of a Factoring Agreement?
Along with fees, there are other conditions that form a factoring agreement. Although getting a good rate might seem like your priority, you should read over the agreement and see what it has to say about these conditions:
- Minimum Sales Commission: Even if you decide not to utilize a factoring company’s service for a month, there tends to be a clause regarding a minimum amount of commission you will be required to pay despite not using their services for a period of time. Not all factors charge a minimum sales commission.
- Escrow: Escrow refers to the holdback on an invoice. For example, if a client sells a $10,000 invoice at a 90% advance, the the factoring company will pay the business $9,000 right away while holding onto the remaining $1,000, in escrow, until the customer pays the invoice.
- Reserve: A reserve account is like a checking account that you have with your factoring company. Any non-funded payments should be deposited into this account. Conversely, any charge backs that need to be made can be taken from your reserves.
- Sale and Purchase Receivables: This part of the contract outlines how the sale and purchase receivables will be handled. Many factoring agreements require your business to sell all of your accounts receivables or your invoices to their service.
Requirements for Factoring Agreements
Depending on the factoring company, the required documentation for an agreement can vary. Some of the key documents that you can be expected to provide when applying include:
- Articles of Incorporation
- Business License
- Corporate tax returns
- Corporate financial statements
- Current aging account receivables and payables
Things to Consider with Factoring Agreements
Similar to signing any contract, it is important to thoroughly review what you are signing. Let’s outline some key details that you should consider when looking over a factoring agreement.
Double-Check all the Details
Review, review, review. It is important to understand the limitations and terms of the agreement. How long is this agreement for? What fees are involved? Are there hidden fees?
Make sure you understand these details to ensure that you aren’t missing anything. Every dollar matters and unexpected fees can set back your business endeavors, so always review the documents carefully, either on your own or with the help of a trusted business partner.
Choose a Reliable Factoring Partner
Once you sign the agreement, the factoring company becomes an extension of your business. Since your clients will be paying your invoices to the factoring company, they will be in direct contact.
The way the factoring company chooses to go about collecting these invoices will be a reflection of your company. Therefore, it is important to choose a factoring company that aligns with your business model and how you conduct your business.
Know Your Obligations
Although this may seem like a no-brainer, understanding your obligations with regards to the contract is essential. Doing this will enable you to prevent paying late fees or penalties. Moreover, if you do not think your business can uphold these commitments, you should aim to renegotiate the terms.
Advantages of a Factoring Agreement
A factoring agreement can alleviate some of the financial stress your business may endure. Not only does it provide you with the immediate funds you need to maintain and grow your business, but it also allows you to monitor the credit of your customers better without having to pay dedicated credit control staff to manage your invoices.
You can always decide to take on more credit if needed, or update the duration of your agreement, depending on your individual business needs. Note that getting a factoring agreement can be relatively easy as long as your customers are creditworthy and you are not tied up in any legal problems.
Start Your Factoring Journey Today!
When expanding a small business, it is important to be able to take on new financial responsibilities. Factoring can be a great support system as it assists you in achieving your business goals.
Prior to signing a factoring agreement, make sure you review not only the terms and conditions involved but also look into how the factoring company conducts their business.
This new company will be acting as an extension of your business, so it is crucial they reflect your company values. Do your due diligence and grow your business today by signing up for invoice factoring.