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Invoice Factoring v. Merchant Cash Advance

As a small-business owner, you need working capital to pay employees and vendors, purchase equipment, and reinvest in business operations. Two funding options are invoice factoring and merchant cash advances, but there are differences between the two. 

What Is Invoice Factoring?

Invoice factoring is not a loan. Instead, you sell your invoices to a factoring company at a discount in exchange for a lump sum of cash. The factoring company collects from your customers, typically in 30 to 90 days.

If you sell products to another business and create a $10,000 invoice, for example, you may need cash to meet payroll before your customer pays off its invoice (typically in 30 days). While you can apply for a bank loan, you need good business and personal credit to qualify and must also put up both business and personal assets as collateral. Moreover, a traditional bank loan can take several months to close.

An invoice factoring company will agree to buy your invoice for $9,500 and charge a 5 percent factoring fee ($10,000 – $500 = $9,500). In a typical invoice factoring transaction, the factoring company will make an initial advance of 85 percent of the invoice value after deducting the fee. In this scenario, the initial advance would be $8,075 ($9,500 X .85 = $8,075). The factoring company then collects the invoice on the due date and provides the remaining balance owed to you ($1,425).

Factoring fees typically range from 1 to 5 percent, based on:

  • The invoice amount
  • You sales volume
  • Your customer’s credit rating
  • The factor type – “recourse” or “non-recourse”

In a recourse factor, you must buy back the receivable from the factoring company if the customer doesn’t pay or replace it with a current receivable of equal value. In a non-recourse factor, you are not required to buy back an unpaid receivable, but you will pay a higher factoring fee because the factoring company is assuming additional risk. 

In sum, invoice factoring provides immediate working capital that covers funding gaps caused by slow-paying customers. Factoring companies don’t focus on your credit rating, but rather the value of the invoices you are selling. So invoice factoring is well-suited for businesses that may not qualify for traditional bank loans. Finally, invoice factoring is unsecured financing, which means it doesn’t require collateral. 

Merchant Cash Advances Also Provide Small Businesses With Working Capital

Like invoice factoring, a merchant cash advance (MCA) is not a loan and provides a lump sum of cash for working capital. But that’s where the similarities end. In short, an MCA is a purchase and sale of future receivables rather than current receivables in exchange for an upfront cash advance.

The advance is repaid through daily deductions of your credit card and debit card sales over the term of the advance, typically 3 to 18 months. Also, a merchant cash advance is based on a factor rate, but this rate is expressed as a decimal figure rather than a percentage. Factor rates can range from 1.2 to 1.5.

For example, if you receive an MCA in the amount of $10,000, and the factor rate is 1.2, the amount you will repay is $12,000 ($10,000 X 1.2 = $12,000). But the actual factor rate e will actually be much higher because the funder will also charge an origination fee and monthly administration fees, which are added to the amount of the merchant cash advance.  

When the factor rate is converted into an interest rate or annual percentage rate, that figure could rise into the double or triple digits. In short, a merchant cash advance is high-cost alternative funding that could easily go into default.  In this situation, both the business’s assets and the owner’s assets are at risk because a typical MCA agreement includes confessions of judgment and personal guarantees, which makes merchant cash advances riskier than invoice factoring. 

The Bottom Line

If you have current invoices but are short on cash, invoice factoring can provide you with quick access to working capital. On the other hand, selling your future receivables in exchange for a  cash advance can also provide your business with much-needed funding. If your business experiences a receivables shortfall, however, you may default on the merchant cash advance, and the consequences will be severe, including the possibility of business bankruptcy. Contact us today to learn more.