What is the Difference Between Factoring and Invoice Discounting?

As a startup owner, you would know that managing cash flow once you start generating sales. Consequently, you may need to look for cash flow management solutions. Two standard options in the United Kingdom are invoice discounting and factoring. While they both provide cash flow solutions, it is essential to understand their distinctions and determine which option suits your startup’s needs. This article overviews invoice discounting and how it differs from factoring.

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What is Factoring?

Factoring is a financing arrangement where a specialised finance firm, known as a factor, purchases your startup’s trade receivables (outstanding invoices) at a discounted rate. The factor then assumes the responsibility of collecting payment from your customers. In a factoring arrangement, your startup essentially transfers the ownership and collection obligation of the invoices to the factor.

Benefits of Factoring

Factoring offers several benefits for mature startups. Firstly, it provides an immediate cash flow injection by converting outstanding invoices into immediate funds. This can help:

• cover operational expenses;
• meet payroll obligations; and 
• fund working capital requirements. 

Secondly, factoring enables startups to:

• outsource the collection process; and 
• save time and resources. 

What is Invoice Discounting?

Under invoice discounting, your startup borrows money from a factor. The loan amount is secured on the value of your invoices. In this arrangement, your startup maintains control over the collection process, maintaining the customer relationship and responsibility for invoice payments.

However, you assign the benefit of the trade receivables to the factor. This gives them the right to receive the payment from the invoices when your customers pay. The factor then deducts the loan balance, interest, and fees from the total invoice. Any balance it pays back to your startup. 

Benefits of Invoice Discounting

Invoice discounting offers certain advantages for startups with a more steady cash flow. First, it provides quick access to cash flow by unlocking the value in outstanding invoices. This can help manage:

• operational expenses;
• bridge cash flow gaps; and 
• pursue growth opportunities. 

Secondly, invoice discounting allows you to:

• control the collections process; 
• preserve customer relationships; and 
• ensure seamless operations.

What is the Invoice Discounting Process?

The process of invoice discounting typically follows the following pattern. Your startup conducts its usual business activities by selling goods or services to customers and issuing invoices. Simultaneously, you notify the factor about the raised invoices. 

After negotiating the terms with the factor, including the discount rate and any applicable fees, the factor advances a percentage of the invoice value (usually 70-85%) as an immediate cash advance. Your startup remains responsible for collecting payments from customers. 

Once the customer pays the invoice, you remit the total amount to the factor, which deducts the advanced funds, fees, and any interest accrued. The remaining balance is then released to your startup.

What Are the Key Differences?

The critical distinction between factoring and invoice discounting lies in obligation, control, and disclosure. In factoring, the factor assumes the responsibility of collecting payments from customers. This relieves your startup of the collection task but requires the disclosure of the arrangement to your customers. 

On the other hand, invoice discounting allows your startup to retain control over the collection process. You maintain the customer relationship and the responsibility for invoice payments without disclosing the financing arrangement to your customers.

Which Short-Term Financing Option is Right for My Startup?

Both factoring and invoice discounting can be valuable cash flow solutions for mature startups. However, it is essential to note that invoice discounting works effectively for startups with:

• sufficient cash flow; and 
• credit management systems in place. 

Factors often require startups to demonstrate a strong track record of collections and cash flow generation. Therefore, a mature startups is more likely to qualify for invoice discounting arrangements if it has:

• an established customer bases; 
• reliable invoicing processes; and 
• efficient credit management systems.

That said, your startup will still need to demonstrate sufficient revenue generation and cash flow management to obtain a factoring arrangement. In practice, you usually need at least £50,000 in annual turnover. 

Key Takeaways 

Mature startups can optimise their cash flow management through short-term financing options, including factoring and invoice discounting. Factoring transfers the obligation to collect on your invoices to the factor, while invoice discounting allows startups to retain control over collections. The two forms of short-term financing depend on cash flow needs, customer relationships, and credit management capabilities. By understanding the differences and suitability of these financing options, mature startups can make informed decisions to support their financial stability and growth aspirations.

If you need help with your startup, our experienced business lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page. 

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