In tough financial situations, most business owners immediately turn to bank loans as a financing option. While these can be a valuable and relatively inexpensive way to get the cash your business needs (especially short-term), they're not always the best financing option. Instead, it may be better to tap into the power of factoring.
But what's the difference between factoring and bank loans? And is one always the right decision?
Factoring versus Bank Loans
You likely already have some idea of how bank loans work. In a traditional environment, a company or individual will borrow money from a lending institution. Over time, the company or individual will work to pay this loan back with interest. Depending on the loan structure, payments may be due monthly, starting immediately, or the full principal and interest will be due at some specified date in the future.
Invoice factoring, by contrast, relies on your existing invoices as a kind of collateral. If you have an invoice that a customer is responsible for paying, you can sell that invoice to a third party for a discount. You'll get an immediate injection of cash, and your customer will pay the third party for the invoice directly.
Advantages of Factoring
There are several advantages to factoring, especially when compared to bank loans.
First, there's no incursion of debt or compound interest. Invoice factoring isn't a loan, per say. Instead, you'll be selling your invoices to a third party for immediate cash. Accordingly, your business won't be incurring any debt, and you won't owe any compound interest. The downside here is that you'll be selling your invoices for a discount-- in other words, you'll be collecting less money than you were originally due. But you won't have debt or interest hanging over your head.
It's also a quick and simple approval process. Depending on the institution and the loan terms, it can take weeks, or even months, to get approved for even a modest-sized loan. By contrast, invoice factoring usually involves a much faster, more streamlined approval process. In line with this, you'll likely be able to capitalize on fast funding. Most invoice factoring institutions make it a point to ensure their clients are funded within a day or two of approval.
Plus, reliability is on customer credit. Banks want to protect themselves financially, so it's understandable that they only lend to businesses and individuals with a high credit score. But with invoice factoring, your credit isn't a problem; your customers are the ones paying the money back, so funding is contingent on their credit.
Finally, there's no strict upper limit. With conventional bank loans and lines of credit, there's a maximum amount of capital you can tap into. But with invoice factoring, you can keep getting more money for as long as you have invoices to sell.
Advantages of Bank Loans
While there are many viable alternatives to bank loans these days, bank loans are still a powerful and advantageous financial tool for startups to wield.
First off, there's a lack of dependence on invoices. The biggest weakness of invoice factoring is that it relies entirely on your company's current invoices. If you don't have a reliable customer base, or if you need an amount of money that exceeds the total of all your outstanding invoices, bank financing may be your only option.
Plus, there's a multitude of options. There's no single description of a "bank loan," since the bank can lend you money in a variety of ways. If you shop around to different lending institutions and you're willing to negotiate a bit, you can often find a great interest rate, impressive terms, and an overall loan structure that serves your needs exactly. You're not locked into only one type of business loan.
Finally, there's flexible repayment. With invoice factoring, you won't be repaying the loan at all, since your customers will be paying back your factor. But in the realm of conventional loans, you'll typically have access to flexible repayment plans. For example, with a floating line of credit, you can often make payments gradually as you see fit.
So is invoice factoring better than bank loans? In some ways, yes. If you have standing invoices that are as-of-yet unpaid, if your company doesn't have the credit to take out a conventional bank loan, or if you need funding fast, invoice factoring is the clear winner of the head-to-head comparison. However, there are still many situations where bank loans are your best-- or only-- option.