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An invoice discount agreement can be an effective way for your startup to manage its cash flow. However, the legal mechanics behind an invoice discount agreement can be complex. Accordingly, you may wish to familiarise yourself with how invoice discount agreements operate from a legal perspective. This article will evaluate important legal considerations to bear in mind before entering into an invoice discount agreement. As you will see, your startup may wish to obtain legal advice because invoice discounting is a complex arrangement.
What is Invoice Discounting?
Invoice discounting is a financing arrangement where your outstanding invoices serve as collateral for a loan provided by a specialised finance company called a factor. The factor typically offers a loan amount between 70-85% of the invoice value, depending on the creditworthiness of your customers. Interest accrues on the outstanding balance daily.
With invoice discounting, you are responsible for collecting the invoices.
There are two types of invoice discounting agreements: undisclosed and disclosed. In undisclosed discounting, the customer is unaware of the arrangement, while in disclosed discounting, the customer is aware and may be included in the legal documents.
Invoice discounting can be recourse or non-recourse. Recourse factoring means you bear the risk of customer non-payment, treating it as a bad debt. Non-recourse factoring transfers the liability of non-payment to the factor. This usually results in a lower percentage of the invoice value offered to compensate for the increased risk.
How Does Invoice Discounting Work?
Invoice discounting functions through a legal process called assignment. Assignment describes an agreement where you transfer the benefit of an asset to a third party. Specifically, you assign trade receivables to the factor. This gives them the legal right to collect the payments when your customers pay the invoice. It creates a corresponding legal obligation on you to pay to the factor the invoice proceeds.
In a standard invoice discounting agreement:
- Your startup conducts its usual sales with a customer.
- Your startup sends an invoice to the customer and simultaneously informs the factor about the raised invoice.
- You negotiate with the factor regarding the value of the discounting agreement. This value typically represents the invoice amount minus a discount, which accounts for the convenience of receiving immediate cash. Additionally, an interest rate is agreed upon.
- After conducting an audit of your collections process, the factor provides an upfront advance, based on the agreed amount.
- Interest starts accumulating on the remaining balance.
- Your startup retains the responsibility of collecting the invoice payment from the customer. Once the customer pays the invoice, you remit the full amount to the factor.
- The factor deducts the advanced funds, any outstanding interest, and applicable fees from the payment. The remaining balance is then released to your startup.
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What Important Legal Considerations Arise Under Invoice Discounting?
Invoice discounting is a kind of short-term debt financing. That is, your business borrows money from the factor. The factor uses your trade receivables as collateral for the loan. The collateral arises via assignment as contained in the invoice agreement. This is a fairly complex legal arrangement.
Accordingly you may wish to familiarise yourself with the various provisions and clauses that may be contained in an invoice discounting agreement.
Discount Agreement
The invoice discount agreement will usually specify that all invoices fall under a discount agreement. It may state that if your company provides an unsuitable invoice, the factor can refuse to advance your startup money.
Discount Amount
The factor usually advances 70-85% of the total invoice value. But the factor may choose to advance a lower amount if it concludes there is a high degree of risk.
Interest and Fees
The factor typically charges between 1-3% interest on top of the base rate for any outstanding balance. It may then charge an additional fee between 0.1%-1% of your total turnover.
Collection
This creates a binding obligation on your startup to collect the invoices on behalf of the factor.
Accounts
The factor does not typically inspect your accounts. Instead, the factor advances the loan amount once you notify it that you have raised the invoice with your startup’s customer. That said, invoice discounting agreements contain an obligation on you to maintain your accounts. In most cases, the factor will also reserve the right to inspect your accounts.
Disapproval
A factor may refuse to collect on a particular invoice for whatever reason. For instance, the factor may be concerned that the payment will be delayed. This is called disapproval. The factor usually retains the right to deduct the amount your startup can drawdown in the future as a result.
Termination
The factor retains the right to terminate the arrangement at any point you breach any of your obligations, no matter how minor. Likewise, if your startup finds itself in insolvency proceedings or any of the directors implicated in fraud, the factor will have the right to terminate the agreement.
Invoice Discounting and Other Forms of Borrowing
If you have any secured loans outstanding, you should seek the advice of a lawyer before you enter into an invoice discounting agreement. This is because secured forms of borrowing may take security over your trade receivables. If you subsequently try and assign these trade receivables to a factor under an invoice discounting agreement, you may breach the terms of the secured loan.
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Key Takeaways
Invoice discounting is a financing arrangement where your outstanding invoices serve as collateral for a loan provided by a specialised finance company known as a factor. With invoice discounting, you remain responsible for collecting the invoices from your customers. It is important to consider the legal mechanics of invoice discounting and seek legal advice, as it is a complex arrangement with various provisions and considerations.
If you need help understanding the key legal considerations to bear in mind when entering into an invoice discount agreement, contact our experienced contract lawyers 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.
Frequently Asked Questions
In undisclosed discounting, the customer is unaware of the arrangement, while in disclosed discounting, the customer is aware and may be included in the legal documents.
You, as the seller, are responsible for collecting the invoices from your customers in an invoice discounting agreement.
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