Invoice factoring is the sale of your accounts receivable to a third party at a discount, in exchange for immediate cash.
Invoice factoring — sometimes called invoice financing or receivables financing — turns unpaid invoices into immediate cash by selling them to a factor at a discount, typically 1-5% of face value. The mechanic addresses a specific pain: you've done the work, sent the invoice, and now have to wait 30-90 days for payment while your payroll and infrastructure costs continue. Factoring gets you paid in 24-72 hours in exchange for a fee. It's a serious tool for businesses with predictable, high-quality receivables (typically B2B services, staffing, freight, manufacturing) and a red flag for businesses using it as a substitute for equity or debt financing that reflects fundamental economics.
(1) You invoice a customer for $100K, 60-day terms. (2) You sell the invoice to a factor for immediate payment of $92-98K (advance rate 80-95%, discount fee 1-5%). (3) The factor collects from your customer at maturity. (4) Any reserve (the difference between advance and full payment) is remitted to you after collection, minus fees. Two flavors: recourse factoring (you're on the hook if the customer doesn't pay — cheaper, easier to qualify for) and non-recourse factoring (factor absorbs credit risk — more expensive, tighter customer eligibility). Notification vs. non-notification: notification means your customer knows you factored (they pay the factor directly, awkward); non-notification means you continue collecting and forward payments. Non-notification is preferred but not always available.
Headline fees look small (1-5% per invoice) but annualize dramatically. A 2% fee on 30-day paper is a ~24% APR; on 60-day paper, ~12% APR. Add setup fees, monthly minimums, wire fees, and unused-line fees, and effective rates commonly land at 15-30% APR. Compare to alternatives: a line of credit from a commercial bank at 8-12% APR, venture debt at 10-15%, or simply accepting slower growth. Factoring is usually the most expensive form of financing per dollar of runway extended — worth it only when the alternative is missing payroll, not when it's slower growth.
(1) Growing services or agency businesses whose customers are large enterprises with 60-90 day payment terms and rock-solid credit. The factor's discount is basically insurance against the mismatch between when you must pay staff and when you get paid. (2) Government contractors — federal customers pay net 30-45 but sometimes drift to 90+, and the receivable is essentially default-free. (3) Bridge financing during a growth spurt where accepting more paid customers is possible but would strain payroll. (4) Sudden large customer wins where accepting the deal requires more working capital than the business has on hand. In each case, factoring solves a timing problem, not a fundamental economics problem.
Factoring becomes a red flag when: (a) it's used to fund operating losses, not working capital timing. If revenue doesn't cover cost of servicing that revenue, factoring extends the ambulance ride but doesn't fix the underlying issue. (b) it's used at rates that meaningfully exceed the gross margin on the underlying work — you're paying a factor more than you're earning per dollar of revenue. (c) the business has become dependent on it as a permanent capital source rather than a transitional tool. (d) it's used to avoid confronting collection problems — some customers pay slowly because the product/service disappointed them, and factoring papers over the signal. Investors read heavy factoring dependence as a negative signal in due diligence.
(1) Accelerated collection incentives — offer a 1-2% discount for 10-day payment. Often cheaper than factoring and doesn't require third-party involvement. (2) Line of credit from a business-friendly commercial bank (SVB successors, Mercury, Brex line of credit for qualified customers). Rates typically 30-50% of factoring. (3) Revenue-based financing (Pipe, Capchase, Wayflyer) for subscription businesses — different mechanic but similar 'unlock committed revenue' function, often cheaper for SaaS. (4) Better payment terms in contracts — for new deals, negotiate 15-day terms or upfront milestones. (5) Simply raising equity or debt at a real cost of capital, if the business economics justify it. Factoring should be a specific tool for a specific problem, not the default answer to 'how do we bridge cash?'
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