If you have a small business, and you would like to expand, then you probably think that you will need to find outside capital, in the form of an angel investor, venture capital, or a bank loan in order to do so.
However, if you are in the manufacturing sector, or even a service provider, who sells to the public sector, then selective invoice factoring, or reverse factoring, may be another funding option for you.
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What Is Reverse Factoring?
One of the main reasons that reverse factoring is not used more often to fund small businesses, and improve their cash flow, is quite simply that many people don’t know what it is, or how it works.
Reverse or selective invoice factoring, in the simplest possible terms, is a system that allows you to borrow capital from a third party, based on and secured by your unpaid invoices. This type of funding can allow you to secure as much as 80% of the invoice value in capital, that you can use to fund the materials and other items you need to complete the project or order.
What Are the Benefits of This Type of Funding?
One of the primary benefits of this type of funding is that in many cases, even small businesses with less than perfect credit records can apply for it. That’s because companies that offer this type of funding base their assessment of the credit worthiness of the deal not on your credit rating, but on that of your client. (Read more about small business funding)
That means that if you are doing business with a large and reputable company, the company that is considering you for funding through factoring will consider their ability to pay their invoice, when deciding whether to proceed with the deal.
Factoring companies often also take over the collections function on invoices that they have factored, which means less work for you in collecting payments from your customers.
Once the invoice is paid, the company who providing the factor funding will deduct the money that they have advanced you on that invoice, as well as their fees (usually a percentage of the value, calculated per day for the duration of the loan) and pay the remaining funds to you.
This type of finance for small businesses is particularly attractive, because in most cases you can obtain funding based on a formal written order from your client, and that means less worrying about how you will finance production.
The final notable benefit of reverse factoring as a source of funding is that you can choose the invoices or projects that you want to finance in this way. If you only have one or two large orders that you need capital to complete, then you need only factor those invoices, and retain the sole right to the remainder of your ledger. This offers more flexibility than traditional finance.
What Are the Drawbacks of This Type of Funding?
The primary drawback to factoring as a source of funding for small business operations is not in the service itself, but in the limitations they place on which invoices they will factor.
Projects undertaken for government and private individuals are not eligible for factoring, and since these are often some of the most lucrative for small businesses, that is a hurdle.
Since the cost of funding by factoring is calculated on a per day basis, another drawback of this type of financing is that if your clients don’t pay on schedule, you could end up paying a lot more than initially anticipated. This risk is offset by the factoring company’s involvement in collections, but it is wise to build a portion of the cost into your pricing calculations, in case it happens.
So, if you are a small business owner looking to expand, but you lack the credit rating and reputation you need to access traditional funding, and if you operate in the public sector, you might just find that factoring is the funding solution you have been looking for.
This post is sponsored by Caban Investments – Caban Investments is an Impact Venture Capital firm, operating across Sub-Saharan Africa. They work with seed, early, and growth stage businesses with the intention to positively impact the environment, societies and economies they operate in. Website: www.caban.co.za
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