What to Know About Factoring Agreements
When you work with a factoring company, you will enter into a factoring agreement prior to the invoice factoring process. With this contract, the business promises the factor that it will sell the invoice in order to be advanced a specific amount. The factoring agreement is a financial contract that explains the costs and terms of accounts receivable factoring for your business, while also addressing fees and other terms.
What is Small Business Invoice Factoring?
Invoice factoring is when a business sells unpaid invoices to a factoring company at a discounted rate. In other words, the business is transferring ownership of invoices in exchange for immediate cash flow. There is no debt incurred with invoice factoring and you are not required to repay the factoring company. Instead, they take on the responsibility of collecting the payment from your customers directly. This system allows you quick access to the funds that are tied up in your invoices to enable you to meet immediate financial needs or invest in business growth. Because the factor assumes the risk of collecting payment, the creditworthiness of your customers plays a crucial role in determining the factoring rate you receive. Industries such as construction or small businesses frequently benefit from invoice factoring.
Qualifications for Invoice Factoring
Businesses can qualify for factoring regardless of their credit standings. They also do not need to be startups. Factoring eligibility is determined primarily by the creditworthiness and stability of the client who will be responsible for paying the invoice. The strength and credibility of the client carries more weight than the creditworthiness of the company seeking factoring. Because of this design, most small business owners, including startups and those with lower credit ratings, are able to qualify for factoring.
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Factoring Agreements Terms to Know
Each factoring agreement will cover certain terms. Depending on the factoring company you are working with, they may vary slightly. However, most factoring agreements typically include the following terms.
Selling Accounts Receivable
Each factoring contract will cover which invoices you will be factoring (selling) to the factoring company, if not all of them. If there are certain accounts receivable you do not want to factor, discuss the matter with the factoring company beforehand.
Approving Credit
As you may know, approval for invoice factoring is not based on your credit, but on the creditworthiness of your clients. Before a factoring company will work with you, they will check your customers’ credit. Therefore, part of the factoring agreement is your consent to let the factoring company conduct credit checks of your customers. An important aspect of this term is to ask what will happen if one of your customers does not want to comply with this step in the factoring process. Ask how much time the factoring company will give you to discuss this with the client before the company drops your account as a whole.
Advance Amount
This is an important part of the factoring agreement because it is the entire reason for using invoice factoring as a financing option. The advance is the percentage of the invoice you get upfront. This amount can change for each company and it depends on many different elements, such as invoice amount, industry, location and other factors.
Termination Provisions
Many factoring agreements have details and rules pertaining to the length of a factoring relationship. Your company will have the right to terminate an agreement, but it is typically outlined in the section how far in advance this must be done. The time period of advance notice will usually be between 30 and 90 days.
Common Factoring Mistakes to Avoid
- Not reading everything: We know a factoring agreement is not the most exciting read, but it is very important to read and understand every detail. Spend time reading the document thoroughly and do not resort to skimming. Ask a trusted partner to read the document to ensure you did not miss any important details. Pay special attention for any type of added fees and ask questions before agreeing.
- Not understanding requirements: Many factoring agreements will have a monthly minimum requirement. Make sure you know what your amount is, if you have one. You could be penalized if you fail to meet the terms of the contract. Ask what the penalties are if you fail to meet the specific terms.
- Not knowing how factoring companies interact with customers: You will want to understand how the factoring company you are working with will collect payments from your customers. Some questions to ask include what will happen if a customer is late with a payment and how will the factoring company follow up with them. These forms of communication are important because they reflect on your business as a whole.
