Credit history and credit scores aren’t the only way to finance a small business. Most lenders use these traditional measurements to determine whether to lend to a small business, but there are a growing number of them that take a broader view. New alternative lenders will look at a business’ outstanding invoices — orders from customers that haven’t fully been paid yet — to make a lending decision.
What is invoice financing?
For business transactions, orders and payments don’t always come at the same time. Especially for larger purchases, there can months in between when an invoice is issued and when a vendor finally receives payment. Any unpaid invoices are considered accounts receivables.
Invoice financing, also called invoice discounting, uses a firm’s account receivables as collateral for a loan. Because there is risk that some of the invoices in accounts receivables won’t pay in full or pay at all, invoice financing typically advances a percentage of the value of all the outstanding invoices. It’s typical for invoice financing to cover 50% to 85% of the total account receivables.
Unlike invoice factoring, which requires a business to sell its invoices to a lender, with invoice financing, the borrowing business retains ownership of its account receivables and maintains its own responsibility for collection from customers.
For businesses with a lot of value tied up in open invoices and long payment cycles, invoice financing can provide immediate cash to help smooth out lumpy cashflows.
How invoice financing works
- Issue invoice: When a customer makes a purchase, a company issues an invoice to the customer. Goods are shipped or service rendered.
- Invoice submitted to lender: Either on an individual basis or part of a group of invoices, that invoice is sent to a lender for review.
- Money advanced: If an invoice is approved, the lender will generally advance up to 85% of the value of the invoice to the company.
- Customer pays off invoice: The financing company will send the remainder (15% – 50%) of the invoice value to the company when the customer pays off the invoice.
- Fees deducted: Invoice financing firms charge a fee for their services. These fees are generally a few percentage points (say, 3%) with additional fees charged the longer the invoice remains unpaid (like 1% per week).
Pros of invoice financing
For firms with long payment cycles and significantly large orders, invoice financing provides a way to unlock the value sitting in those orders. Invoice financing provides:
- speed: Instead of waiting for payment, vendors can get paid upfront. No waiting around for customers to pay — these orders can go straight towards working capital.
- part of general business flow: Companies don’t have a lot of extra steps involved to receive invoice financing. They sell and issue invoices anyway. And with invoice financing (as opposed to factoring, which is different), they retain the payment relationship with their customers and don’t give that up to a third party.
- relies on customer, not vendor, credit: When you get a plain vanilla loan from a lender, they’ll use your company’s credit (and your personal credit, probably) to decide whether or not to issue you a loan. Your credit score and credit history will determine whether you receive a loan. With invoice financing, the financing firm will look at the credit history and score of the customers, because it matters how likely they are to pay you back. This works particularly well if you have blue-chip customers.
Cons of invoice financing
Invoice financing isn’t for everyone. There are drawbacks, too.
- cost: The fees on invoice financing can be significantly higher than other forms of borrowing. Fees run higher the longer the invoice remains open, so companies with really long payment cycles or lower-quality customers will experience even higher fees.
- poor optics: Invoice financing might be a negative signal to everyone in your business ecosystem that you’re hard up for cashflow. Sending a red flag to partners, customers, and suppliers may cause them to rein in the credit they extend to your business or look elsewhere to bring their business.
- Affects other forms of financing: Traditional lenders will include account receivables in their decision to extend credit to a company. If accounts receivables are already collateralized through invoice financing, they may not be seen as an asset for another lender.
Who’s right for invoice financing
Theoretically, any company can apply and receive invoice financing. But this form of short-term loan is particularly designed for:
- companies with long payment cycles
- companies with blue chip customers
- companies with a lot of money tied up in their account receivables
Difference from invoice factoring
Many writers confuse or conflate invoice financing with invoice factoring. In fact, they are similar, but different types of financing.
Invoice factoring works like invoice financing in that a lender issues a short term loan off of the value of a firm’s invoices. The major difference is that with invoice factoring, a company actually sells off their invoices to its lender and the lender takes over collection responsibilities for its account receivables. That means a relationship like this is disclosed to a company’s customers and that they’ll interact with the factoring company on payment for their purchases.
There’s no hard or fast rule for which companies use invoice factoring versus invoice financing. Younger firms with lower revenues generally use invoice factoring and more established, larger firms turn to invoice financing.
Online providers of invoice financing
There are a lot of new lenders who offer invoice financing and/or factoring: