Many businesses have used invoice factoring to smooth out an unpredictable cash flow and achieve stability and growth. 

But before you sign a factoring contract, make sure you understand what you’re getting into. Factoring can be an affordable, debt-free way to access working capital, but it can also be a restrictive and costly financial arrangement. The devil is always in the details.

In this blog post, we’ll look at five areas to pay special attention to when reviewing a contract from a potential factoring partner.

Fee structure 

Factoring fees are rarely structured as a single flat rate. Most agreements specify a tiered fee schedule that increases the longer an invoice remains unpaid. In other words, if a customer pays late, you receive a lower percentage of the face value of the invoice, which can make the total cost of factoring higher than the basic rate suggests. 

To ensure you understand the true cost of factoring, scan the contract for these details:

Advance rate

The advance rate is the amount you receive from the factor as soon as you invoice your customer, and it can be based on the gross amount (the face value of the invoice) or a net amount that includes deductions for early-payment discounts or short payments. It can also be tiered, with lower percentages applied to situations where the invoice is for a large amount or billed to a customer with a lower credit rating or in a less stable industry.   

Discount fee

The discount fee (also called the “discount rate” or “factoring fee”) is the core fee the factoring company charges for purchasing the invoice, taking on the risk, and extending the use of their capital to you. This fee is defined in terms of a percentage, which often increases as the invoice ages. Make sure you understand how that fee is applied and how it affects the total cost of factoring.

Other fees

On top of the discount fee, a factoring firm may charge additional fees, such as origination fees, due diligence fees, wire fees, ACH fees, monthly minimum volume fees, lockbox fees, and fees for early termination.

Fee schedule

Factoring fees and the cash required to cover chargebacks typically come out of a reserve account funded by proceeds from your factored invoices. The reserve may be structured on a per-invoice basis or as a rolling or pooled reserve. A per-invoice reserve can make it easier to track the funds associated with each invoice and may release cash sooner as individual invoices are paid. A pooled reserve, however, can provide a company with a readily available source of cash that it can draw upon when needed. For businesses that do not require every available dollar immediately, allowing the reserve to build can also reduce unnecessary funding costs and help preserve working capital. Before signing a factoring agreement, make sure you understand how the reserve is structured, when funds are released, and whether you have the flexibility to choose when to draw available funds. A strong factoring partner should provide clear terms and enough flexibility to align the reserve structure with your company’s cash-flow needs.

Customer eligibility criteria

Read the contract definitions around eligibility carefully. Some agreements give factors the freedom to retroactively change the acceptance criteria, which can suddenly disqualify a specific invoice or customer from factoring. If the factor reserves the right to retroactively change eligibility criteria, it means your cash flow can suddenly and unexpectedly dry up. Ideally, the agreement will specify that the factor is required to provide prior notice before disqualifying invoices or customers from the factoring arrangement. This gives customers more predictability around their cash flow. 

Concentration limits

Concentration limits put a cap on the percentage a single customer can represent of the total factoring facility. For example, if the concentration limit is 10% and the factoring facility tops out at $100,000, it means that no single customer can represent more than $10,000 in outstanding invoices. This can pose a problem for customers with one or two large customers whose invoices they want to factor. 

Aging restrictions

Check the language around invoice aging restrictions. Agreements can exclude invoices once they pass a specific number of days outstanding, with invoices that cross that threshold becoming ineligible for factoring and charged back to the company. If the contract includes a 60-day aging restriction and one or more of your invoices remains unpaid at 61 days, you may be required to repay the factor any advance funds immediately, even if you entered into a non-recourse factoring arrangement. 

Other exclusions

Remember that factors can exclude invoices based on any criteria they choose. Look for unique exclusions that could impact your ability to maintain the type of cash flow you need. Some factors refuse to factor invoices from companies that are affiliated or related to yours. Others may exclude government or foreign receivables. Some do not fund invoices that are progress- or milestone-based. 

The way eligibility and approval are defined in a contract is important. Make sure you understand the definition of each and that these definitions align with your factoring and cash flow needs. 

Ultimately, a company should ask for a clear, current list of approved customers and credit limits before signing, and clarify how often and under what process that list can change without notice.

Recourse vs. non-recourse

A recourse agreement means the factor can claw back the funds if your customer doesn’t pay their invoice, while a non-recourse agreement means the factor is technically on the hook for any uncollected funds. 

That makes non-recourse factoring seem like a better deal, but there’s more to the story. Non-recourse factoring is generally a more expensive financing option, with lower advances and much higher fees. Also, the situations in which the factor will actually shoulder the risk of nonpayment tend to exclude the most common reasons for non-payment or short payment, including billing disputes, chargebacks, short payments, and breach-of-contract situations. If you choose non-recourse factoring, it’s important to carefully read the parts of the contract that outline the risks the factor is willing to assume on your behalf so that you can decide whether the additional costs are worth it.

Termination clause

Check the language that defines termination and wind-down of your contractual relationship with the factor. In other words, how long does the contract lock you in for? 

Many factoring agreements auto-renew for lengthy terms (one year is common) unless cancelled within a narrow notice window, and early termination fees can be substantial, sometimes calculated as a percentage of the facility size or remaining contract value regardless of your actual usage of the facility. 

Check the wording that defines the circumstances under which you or the factoring firm can break the contract, what penalties are applied for early release, and how long the factoring firm holds onto the reserve before releasing the cash to you. Most factors will hold the funds for a certain number of days after termination to cover any trailing chargebacks, but the longer the hold period, the longer that cash is tied up. 

Reporting and auditing

Factoring can be confusing if you are new to the process, so it’s important to be able to see regular, itemized statements showing exactly how the reserve balance is calculated and what fees have been deducted. The contract should clearly define the type and frequency of reporting you can expect from the factoring company and what rights you have in terms of auditing and disputing those calculations. 

At a minimum, you want assurance that the factor will submit a report at least monthly, and that the report includes:

• Your opening and closing balance
• Details of every invoice submitted during the period
• The advance amount paid out for accepted invoices
• The advance rate applied to each invoice
• The date the advance was funded
• A standard invoice aging schedule for each customer
• A list of fees deducted from the reserve during the reporting period
• Any changes in a customer’s credit limit or approval status

Factoring can be a life-saver for companies that need to meet payroll, expand rapidly, fund startup costs, or bridge a cash gap. But before you sign, pay attention to the most important areas of the contract—the fee structure, the eligibility criteria, the termination process, and the reporting. If something doesn’t make sense, ask questions. If you still have concerns, talk to a trusted broker or banker to get their perspective. 

Interested in exploring your factoring options? Talk to a factoring expert in your region.