Factoring is a working capital solution where a company sells its accounts receivable to a specialized lender (the factor) at a discount, typically 2-5% below face value. In exchange, the company receives immediate cash instead of waiting 30-60+ days for customer payments. The factor then collects payment directly from the customer, absorbing both the collection risk and administrative burden.
How It Works
The mechanics are straightforward: a business generates an invoice and sends it to the factor instead of waiting for customer payment. The factor advances 70-90% of the invoice value immediately, less their fee. Once the customer pays, the factor releases the remaining balance (minus their fee and any interest). This is different from a traditional loan—there's no debt obligation, just a sale of assets. The factor's profit comes from the discount between what they pay upfront and what they collect from the customer.
Why It Matters for Investors
For angel investors and venture capitalists, understanding factoring reveals how portfolio companies manage cash flow challenges. Fast-growing businesses often face the working capital paradox: they're profitable on paper but cash-constrained because customers pay slowly. Factoring allows these companies to reinvest revenue into growth, inventory, or hiring without waiting for customer payments. As an investor, you should recognize that excessive reliance on factoring (high discount rates) can signal unhealthy cash conversion cycles or weak customer creditworthiness.
Example
A SaaS company lands a major enterprise client with a $100,000 contract but must wait 60 days for payment. Rather than pause operations, they sell that invoice to a factor for $97,000 immediately. The company uses that cash to hire engineers and expand their service offering. When the customer pays in 60 days, the factor receives the full $100,000 and keeps the $3,000 difference as their fee. The company accelerated growth; the factor earned a return on their capital.
Key Takeaways
- Factoring converts future customer payments into immediate working capital—useful for managing growth without external debt
- Factors charge fees (2-5% typically) and assume collection risk, making this solution most viable for businesses with creditworthy customers
- Unlike traditional bank financing, factoring doesn't create debt on the balance sheet, though it does reduce revenue recognition
- High factoring dependency can indicate cash flow problems or poor customer concentration, both red flags for investors evaluating business health