On the road to small business growth, access to capital is often the major bottleneck. Young businesses often don’t have the backlog of success that traditional lenders want to see to make a decision. That leaves you, the business owner, stuck in third gear, pumping the brakes instead of opening things up.
We can ditch the driving metaphor at this point.
Non-traditional lending comes with it’s own set of problems, mainly revolving around the high cost of capital. Since your business is an unknown quantity, lenders look to higher rates to make up for the increased risk of default.
Invoice-based financing tries to walk a thin line between uncollateralized, credit-based financing – a credit card or classic business loan – and a line of credit based on collateral. This allows young businesses to access capital, as long as they’re bringing in business.
This isn’t as simple as it seems, so you don’t jump in with both feet without doing the research. Hence, this post.
What is invoice-based financing?
Invoice-based financing is a way to gain access to credit by borrowing against uncollected invoices. In effect, you sell off a future income stream for a discount in order to gain instant access to the money those streams promise.
Let’s talk real life examples. You’re a web design business with a bunch of local customers. These people are great. Of course, I am kidding. Your clients are death and taxes when you’re working on their site, but, as soon as payment is due, you’re hunting them down like Private Ryan.
Invoiced-based financing turns potential payments into an actual payment, based on a series of factors. First and foremost is risk. You did a $100,000 job for Tina, the owner of an as-of-yet unopened winery. Well, you’re not going to get a lot of credit for that. Conversely, you did a $2,000 for the local IBM office. That’s gold.
The lender will take the invoices you bring to them, figure out how much you got – let’s say it’s $150,000 – and give you somewhere between 75 percent and 90 percent of the total value up front. You’ll still get the remaining value once the invoice is paid.
Once you’ve got this bundle of invoices, you can approach an invoice-based financing lender to see what options you have. The first thing you’ll discover is that this kind of lending comes in two main flavors – invoice factoring and invoice discounting.
Invoice factoring compared to invoice discounting
When you get financing through an invoice factoring firm, that firm will take on the collection of the debts you’ve borrowed against. That means the lender will be the one that accepts and processes payments for the invoices.
This has the upside of taking a lot off your plate. You won’t have to worry about chasing down clients or keeping track of payments they’ve made and payments you owe the lender. The major downside of factoring is its impact on the customer experience.
Since the customer is paying the factoring firm, they’ll know that you’re using a lender. That can affect the work they seek from you and the amount they’re willing to pay. Invoice factoring is a nice option for smaller businesses because it takes some of the pressure off the business.
Invoice discounting is more like a revolving credit line, where each invoice you send is also sent to the lender, who will then release a percentage of the invoice to you immediately. Instead of using a bundle of debt to borrow against, you’re borrowing against your ongoing revenue stream.
Invoice discounting leaves the collection to you, the business owner. This is great for larger companies, as they usually have a collection system in place already. In effect, you’re just getting paid sooner – for a fee.
Fees for invoice-based financing
When you borrow against your debts, you’re borrowing against an asset. Invoice factoring and invoice discounting are simply two versions of the same secured loan. That means that you’re going to pay interest on the loan and fees on the service.
There are lots of different systems for determining how interest is charged. The lender may apply an interest charge on a daily or weekly basis, or you may be charged a flat interest rate. This is, of course, on top of the fee you’ll pay upfront.
Even with all these fees, you’re still in a good place. Because invoice-based lending is a secured loan, interest rates are going to be lower than if you just asked for cash with no backing.
Obviously, rates will depend on who you are, who you work with, how much capital you need, and what the prevailing interest rates look like. Keep in mind that the length of these loans is usually spelled out days or months, not years. That means that your APR is going to be high, while the total you pay will be lower.
For instance, if you borrow $100,000 at a 17 percent APR for 90 days, you’ll pay $4,250 in interest.
Final thoughts on invoice financing
Borrowing against your future revenue can be a great way to get financing, especially if you’re that young business with plenty of customers and a dearth of payment history. You’ll get cash up front, unlocking your ability to make necessary purchases ASAP.
On the other hand, if you can manage to get a revolving line of credit from a bank, you’ll probably want to just skip over this sort of borrowing. It’s more expensive than borrowing from a bank and requires more hoop jumping along the way.
If you’re interested in this sort of financing, I’d recommend checking out a comparison site like Fundera or Lendio. You should also talk to your accountant and your bank, as they may have a better idea of the available options and how your choice will impact your business overall.
If you’ve had experience with invoice-based funding or another non-classic funding source, I’d love to hear about it. Please drop a line in the comments or shoot me an email. If you want more small business tips and insights, swing over to Capterra’s Knocking Down Doors blog. Good luck.