The case for making invoice factoring the first choice in business financing

The case for making invoice factoring the first choice in business financing

The case for making invoice factoring the first choice in business financing

In the United States, invoice factoring is often perceived as a “financing option of last resort.” In this article, I argue that invoice factoring should be the first option for a growing business. Debt and equity financing are options for different circumstances.

Two key inflection points in the business life cycle

Inflection point one: New business. When a business is less than three years old, opportunities to access capital are limited. Debt financing sources look for historical revenue data that shows debt service capacity. A new business doesn’t have that history. This makes the risk of debt financing very high and significantly limits the number of available sources of debt financing.

When it comes to equity financing, equity investment dollars almost always come in for a piece of the pie. The younger, less proven the company, the higher the percentage of equity that may have to be sold. A business owner must decide how much of his or her company (and therefore control) they are willing to give up.

Invoice factoring, on the other hand, is an asset-based transaction. It is literally selling a financial instrument. This instrument is a business asset called an invoice. When you sell an asset, you are not borrowing money. Therefore, you do not go into debt. The invoice is simply sold at a discount from face value. This discount is usually between 2% and 3% of the revenue represented by the invoice. In other words, if you sell $1,000,000 in invoices, the cost of money is 2% to 3%. If you sell $10,000,000 in invoices, the cost of money is still 2% to 3%.

If the business owner chooses Invoice Factoring first, he/she will be able to grow the company to a stable point. This would facilitate access to bank financing. And that would provide more bargaining power when discussing equity financing.

Inflection Point Two: Rapid Growth. When a mature business reaches a point of rapid growth, its expenses may outpace its revenues. This is because the customer’s remittance for the product and/or service comes later than things like payroll and vendor payments need to be done. This is when a company’s financial statements can show negative numbers.

Debt financing sources are extremely hesitant to lend money when the business is showing red ink. The risk is considered too high.

Sources of equity financing see a company under great stress. They recognize that the owner may be willing to give up additional capital to obtain the necessary funds.

Neither of these situations benefit the business owner. Invoice factoring would provide much easier access to capital.

There are three main criteria for accepting invoices.

  1. The business must have a product and/or service that can be delivered and invoiced for. (Pre-revenue companies have no receivables and therefore nothing that can be factored.)
  2. The company’s product and/or service must be sold to another business entity or government agency.
  3. The entity to whom the product and/or service is being sold must have decent business credit. That is, they a) must have a history of paying invoices on time and b) cannot be in default and/or on the verge of bankruptcy.

Summary

Invoice factoring avoids the negative consequences of debt and equity financing for both young and fast-growing businesses. It is an instant solution to a temporary problem and can, when used correctly, quickly bring the business owner to the point of accessing debt or equity financing on his or her terms.

It’s a much more comfortable place.

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