Table of Contents
One of the issues that startups face is securing financing. We tend to think of financing as long-term financing. That is, raising equity or long-term debt. However, short-term financing is another essential consideration. This is especially true for cash-strapped startups. Invoice discounting is a form of short-term financing that can help with cash flow challenges. Under an invoice discounting agreement, a special financial business called a factor loans you money against the value of your unpaid invoices. Your startup remains responsible for collecting the invoice and repaying the factor. This article will examine what invoice discounting is in more detail.
What is Invoice Discounting?
Under an invoice discounting agreement, your trade receivables, that is, your outstanding invoices, serve as collateral for a loan given to you by a factor.
A factor is a special finance company that specialises in providing short-term financing arrangements based on the value of a business’s trade receivables. In short, the factor will typically offer you a loan amount between 70-85% of the value of your trade receivables. The exact amount depends on the creditworthiness of your customers.
In an undisclosed discounting agreement, the customer is unaware of arrangements between you and the factor. But under a disclosed discounting agreement, the customer is aware. In this case, you will typically include the customer in the legal documents used to create the invoice discounting agreement.
Invoice discounting can take the form of recourse or non-recourse discounting. Recourse factoring means you retain the risk that one or more of your customers will not pay their invoices. If this happens, you must treat the non-payment as a bad debt, which you deduct as an expense in your accounts.
Under a non-recourse discounting agreement, the factor assumes non-payment liability on your behalf. Usually, the factor will offer you a lower percentage of the face value of your trade receivables to compensate them for the increased risk that your customer will not pay.
LegalVision’s Startup Manual is essential reading material for any startup founder looking to launch and grow a successful startup.
How Does Invoice Discounting Work?
Invoice discounting operates by a unique legal mechanism known as an assignment. Trade receivables are a form of current asset capable of being bought, sold, or assigned. When you assign something to another person, you essentially transfer the benefit you receive from another party (your customer) to another party (the factor).
A typical invoice discounting agreement looks like this:
- Your startup sells its goods or services to a customer as it usually would.
- Your startup invoices the customer and simultaneously notifies the factor that it has raised the invoice.
- You will negotiate with the factor the value of the discounting agreement. This will usually be the value of the invoice minus a discount to reflect the convenience you receive by obtaining cash upfront. You will also agree on a rate of interest.
- The factor advances this amount upfront, typically after undertaking an audit of your collections process.
- Interest accrues on the outstanding balance.
- Your startup remains responsible for collecting the invoice amount from your customer. When your customer pays the invoice, you pay the total amount to the factor.
- The factor deducts from this amount the funds advanced, any outstanding interest, and any additional fees. It then releases the remaining balance to your startup.
Call 0808 196 8584 for urgent assistance.
Otherwise, complete this form and we will contact you within one business day.
Is Invoice Discounting Right for My Startup?
Factors tend to only enter into invoice discounting agreements with businesses that can demonstrate strong credit management and collections systems. Therefore, your business will have to demonstrate a sufficient degree of collection and cash-flow generation. As a result, if your startup does not have an established customer base, you are unlikely to find a factor prepared to offer you invoice discounting.
It follows that your startup must demonstrate proof of concept. Therefore, invoice discounting is not relevant for early-stage startups.
Invoice Discounting vs Factoring
Avoid confusing factoring and invoice discounting. Although the two share similarities in that they are both forms of short-term financing, there are key differences. The biggest one is that you remain responsible for collecting your invoices under an invoice discounting agreement. Consequently, invoice discounting gives you more control over the collections process. You are not necessarily obligated to inform your customer that you are using an invoice discounting service.
Key Takeaways
Invoice discounting is a short-term financing option that can be advantageous for startups in effectively managing their cash flow. By using outstanding invoices as collateral, businesses can secure a loan from a specialised finance company called a factor. The loan amount is typically a percentage of the invoice value based on the customer’s creditworthiness. With invoice discounting, startups retain the responsibility for collecting the invoices. Businesses must demonstrate robust credit management and collections systems to qualify for invoice discounting.
If you need help with your startup, our experienced startup 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.
We appreciate your feedback – your submission has been successfully received.
