In the US, invoice factoring is often perceived as a “financing option of last resort”. In this article, I am arguing that invoice factoring should be the first option 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, opportunities for access to capital are limited. Sources of debt financing look for historical earnings figures that show the ability to service the debt. A new company does not have this history. This makes the risk of leverage very high and severely limits the number of leverage sources available.
As far as equity financing goes, equity investments are almost always a piece of the pie. The younger and less tried the company, the higher the percentage of equity that may 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 business. 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. So don’t go into debt. The bill is simply sold at a discount to face value. This discount is generally between 2% and 3% of the sales represented by the invoice. In other words, if you’re selling $1,000,000 worth of bills, the cash cost is 2% to 3%. If you’re selling $10,000,000 worth of bills, the cash cost is still 2% to 3%.
If the business owner would opt for invoice factoring first, he would be able to lead the business to a stable point. This would make access to bank financing much easier. And it would offer 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 revenues. That’s because the customer transfer for the product and/or service comes later than things like payroll and supplier payments need to take place. This is a time when a company’s financial statements can show negative numbers.
Debt funding sources are extremely reluctant to lend money when a company is showing red ink. The risk is judged to be too high.
Equity funding sources see a company under a lot of stress. You acknowledge that the owner may be willing to give up additional equity to obtain the funds required.
None of these situations benefit the business owner. Invoice factoring would make access to capital much easier.
There are three primary underwriting criteria for invoice factoring.
The company must have a product and/or service that can be delivered and invoiced for. (Companies before sales have no receivables and therefore nothing to account for.)
Company’s product and/or service must be sold to another business entity or to a government agency.
The company to which the product and/or service is sold must have an appropriate commercial credit rating. This means they must a) have a history of paying bills on time and b) not be in default and/or on the brink of bankruptcy.
Invoice factoring avoids the negative consequences of debt and equity financing for young and fast-growing companies. It represents an immediate solution to a temporary problem and, if used correctly, can quickly bring the business owner to the point where they can access debt or equity financing on their terms.
This is a much more convenient place.