In the United States, Invoice Factoring is often perceived as the “financing option of last resort.” In this article, I make the case that invoice factoring should be the first choice for a growing business. Debt and equity financing are options for different circumstances.
Two key inflection points in the business life cycle
Tipping point one: a new business. When a business is less than three years old, options for access to capital are limited. Debt finance sources look for historical revenue figures that show debt service capacity. A new business doesn’t have that story. That makes the debt financing risk very high and greatly limits the number of debt financing sources available.
When it comes to equity financing, Equity Investment dollars almost always come for a piece of the pie. The younger and less proven the company, the higher the percentage of equity that will need to be sold. The business owner must decide how much of his business (and therefore control) he is willing to relinquish.
Invoice factoring, on the other hand, is an asset-based transaction. It is literally the sale of a financial instrument. That instrument is a business asset called an invoice. When you sell an asset, you are not borrowing money. Therefore, you are not going to get into debt. The bill is simply being sold at a discount from face value. That discount is generally between 2% and 3% of the revenue represented by the invoice. In other words, if you sell $1,000,000 worth of invoices, your cost of money is 2% to 3%. If you sell $10,000,000 worth of invoices, your cost of money is still 2% to 3%.
If the business owner chose invoice factoring first, they could grow the business to a steady state. That would greatly facilitate access to bank financing. And it would provide greater bargaining power when discussing equity financing.
Tipping point two: rapid growth. When a mature company reaches a point of rapid growth, its expenses can exceed its income. This is because the customer’s remittance for the product and/or service arrives later than things like payroll and vendor payments need to be done. This is a time when a company’s financial statements can show negative numbers.
Debt financing sources are extremely reluctant to lend money when a company is in the red. The risk is considered too high.
Equity funding sources see a company under a lot of stress. They recognize that the owner may be willing to forego additional equity to obtain the necessary funds.
Neither of these situations benefits the business owner. Invoice factoring would provide much easier access to capital.
There are three main underwriting criteria for invoice factoring.
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The company must have a product and/or service that can be delivered and for which an invoice can be generated. (Previous revenue companies have no accounts receivable and therefore nothing that can be factored.)
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The company’s product and/or service must be sold to another business entity or a government agency.
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The entity to which the product and/or service is sold must have decent business credit. That is, a) they must have a history of paying invoices in a timely manner and b) they cannot be in arrears and/or on the verge of bankruptcy.
Summary
Invoice Factoring avoids the negative consequences of debt financing and equity financing for young and fast growing companies. It represents an immediate solution to a temporary problem and can, when used properly, quickly bring a business owner to the point of accessing debt or equity financing on their own terms.
That’s a much more comfortable place to be.