In the United States, Invoice Factoring is often perceived as the “financing option of last resort.” In this article, I argue that invoice factoring should be the first choice for a growing business. Debt and equity financing are options for different circumstances.
Two key turning points in the business lifecycle
Turning point one: a new business. When a company is less than three years old, the options for access to capital are limited. Debt financing sources look for historical revenue figures that show the ability to service the debt. A new business doesn’t have that story. That makes debt financing risk very high and greatly limits the number of available debt financing sources.
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 their business (and therefore control) they are willing to give up.
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 will not go into debt. The bill is simply 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, the cost of money is 2% to 3%. If you sell $10,000,000 worth of invoices, the cost of money is still 2% to 3%.
If the business owner chose invoice factoring first, he could grow the business to a stable point. That would greatly facilitate access to bank financing. And it would provide greater bargaining power when discussing equity financing.
Turning 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 supplier payments need to take place. This is a time when a company’s financial statements may 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 capital 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.
The company must have a product and/or service that can be delivered and for which an invoice can be generated. (The above revenue companies have no accounts receivable and therefore nothing that can be factored.)
The company’s product and/or service must be sold to another business entity or government agency.
The entity to which the product and/or service is sold must have a decent commercial credit. That is, a) they must have a history of paying bills in a timely manner and b) they cannot be in arrears and/or on the verge of bankruptcy.
Invoice Factoring avoids the negative consequences of debt financing and equity financing for young and fast-growing businesses. It represents an immediate solution to a temporary problem and can, when used properly, quickly bring the business owner to the point of accessing debt or equity financing on their own terms.
That’s a much more comfortable place to be.