Recourse factoring holds businesses responsible for unpaid invoices, offering lower fees, while non-recourse factoring shifts the risk to the factoring company, providing more protection but at a higher cost.
When considering invoice factoring to improve your cash flow, it’s important to understand recourse vs non-recourse factoring, what the differences are, and how those differences impact your business. Both options have their benefits and drawbacks, and the right choice depends on your business’s financial needs, customer base, and risk tolerance. This comprehensive guide explores the differences between the two, helping you make an informed decision.
What is Invoice Factoring?
Invoice factoring is a financial tool that allows businesses to sell their unpaid invoices to a factoring company in exchange for immediate cash. This provides businesses with the liquidity they need to cover expenses, pay employees, or invest in growth opportunities without waiting 30-90 days for customer payments.
Learn more about invoice factoring here: Factoring 101: The Ultimate Guide to Invoice Factoring
There are two primary types of factoring agreements:
- Recourse Factoring
- Non-Recourse Factoring
Understanding how these work, and what they mean for your business, is important in establishing a healthy factoring relationship.
What is Recourse Factoring?
In recourse factoring, the business (referred to as the “client”) retains responsibility for unpaid invoices. If the factoring company cannot collect payment from your customers, you must repay the advance or replace the unpaid invoice with another one of equal or greater value.
Recourse factoring is the most common form of factoring, since it comes with lower fees and more lenient approval requirements.
One way to think about recourse factoring is to use consider return policies at retail stores. If you go to Walmart and purchase an item, and that item is defective, you as the customer have the right to return that item and receive a refund, or trade it in for an item that is not defective. The same is true for the factoring company when using recourse factoring. If you sell invoices that are not going to be paid within the agreed upon timeframe (defective), the factor has the right to receive a refund for their purchase.
Chargebacks in Factoring
This refund is often referred to as a chargeback. Some factoring companies may take the refund from the reserve account, others may deduct it from the next advance or replace the chargeback invoice with new invoices. If these options are not available or not sufficient, the factor may require you to send them the refund for the chargeback invoices.
How Recourse Factoring Works
To break it down in a step-by-step process:
- You sell your invoices to the factoring company.
- The factoring company advances you a percentage of the invoice value (usually 80-95%).
- The factoring company collects payment directly from your customer.
- If the customer fails to pay within the agreed timeframe, you are responsible for reimbursing the factoring company.
What is Non-Recourse Factoring?
In non-recourse factoring, the factor assumes the risk of non-payment if your customer becomes insolvent or files for bankruptcy. However, this does not cover all scenarios. For example, if the customer refuses to pay due to a dispute over the product or service, you may still be liable.
There may be some non-recourse agreements that cover more than customer insolvency or bankruptcy, but you will have to read the fine print carefully to ensure that you are getting a true non-recourse product.
How It Works
- You sell your invoices to the factoring company.
- The factoring company advances you a percentage of the invoice value.
- The factoring company assumes the risk of customer insolvency and collects payment directly from your customer.
- If the customer cannot pay due to bankruptcy, you are not required to reimburse the factoring company.
Comparing Recourse and Non-Recourse Factoring
So what are the advantages of each form of factoring, and what drawbacks should a business owner consider when evaluating these two alternatives?
Advantages of Recourse Factoring
Recourse factoring places more risk on you, the client. So why would a business consider recourse factoring if the factor can just return the invoice if it doesn’t pay? Isn’t the point of a factoring company to offload the risk of nonpayment? Yes and no. Cash flow is the primary benefit of invoice factoring. A business with steady cash flow is far better equipped to manage expenses and take advantage of growth opportunities. Recourse factoring still provides steady cash flow, as well as a few other advantages:
Lower Fees:
Since the factoring company takes on less risk, reserving the right to return bad invoices, they are often able to offer lower fees. The lower the risk to the factor, the lower the fees. Additionally, a factor may be able to offer higher advance rates, giving your company more money upfront.
Faster Approvals:
With less risk involved, recourse factoring agreements generally have more lenient underwriting standards and so are typically easier to secure.
Better for Reliable Customers:
If your customers have a strong history of timely payments, recourse factoring can save your business money. If your customers are less dependable, you will probably have to deal with more chargebacks.
Drawbacks of Recourse Factoring
Risk of Responsibility:
Businesses with high-risk or unpredictable customers may find recourse factoring too risky. If a customer defaults, you must repay the factoring company or provide a replacement invoice. The good news is, that’s why the reserve account exists. The factor may use the reserve account, deduct the funds from the next advance, or require repayment in another form.
Administrative Burden
In recourse factoring, the factor is not ultimately responsible for collections. If an invoice ages beyond the agreed upon timeframe and is charged back to you, then you are then responsible for the accounting and the collections for that invoice.
Advantages of Non-Recourse Factoring
Risk Mitigation:
Non-recourse factoring protects your business from bad debt caused by customer insolvency. This could save you money, if your customers go under, and give you more peace of mind.
Customer Credit Screening:
Many non-recourse factors offer credit checks on your customers, helping you make informed decisions about whom to do business with. Some recourse factoring companies also offer this service.
Drawbacks of Non-Recourse Factoring
Higher Costs:
Because the factoring company assumes more risk, non-recourse factoring typically comes with higher fees. If you have reliable customers who pay on time, non-recourse factoring would only cost you more.
Limited Coverage:
Many non-recourse agreements only cover customer insolvency or bankruptcy, not payment disputes or delays. This means that you may still face chargebacks, like with recourse factoring, while paying higher fees. This leads some industry professionals to assert that “there are no true non-recourse agreements”, since most agreements still allow the factor to chargeback the invoice if there is a dispute, placing the burden of collection back onto the business after having charged a higher fee.
Stricter Customer Requirements:
Factors offering non-recourse agreements may have more stringent credit requirements for your customers. Since they are assuming more risk, they may prohibit you from working with certain customers (or at least refuse to factor invoices to those customers).
Key Differences Between Recourse and Non-Recourse Factoring
Feature | Recourse Factoring | Non-Recourse Factoring |
Risk Responsibility | Business is responsible for unpaid invoices. | Factor assumes risk for customer insolvency. |
Fees | Lower fees due to reduced risk. | Higher fees due to increased risk. |
Advance Rates | Typically higher (up to 95%). | Typically lower (80-90%). |
Risk Coverage | No protection against customer insolvency. | Protection against insolvency, but not disputes. |
Customer Requirements | Less stringent credit checks. | More rigorous creditworthiness requirements. |
Best For | Businesses with reliable customers. | Businesses in high-risk industries or dealing with uncertain customers. |
When to Choose Recourse Factoring
Recourse factoring is an excellent choice if:
You Have Reliable Customers:
If your customers have a history of paying on time, the risk of unpaid invoices is low, making recourse factoring the most cost-effective.
You Want to Save on Fees:
Lower fees mean more cash stays in your pocket, preserving your profit margins.
Your Industry is Low-Risk:
Businesses in stable industries with predictable payment cycles (e.g., healthcare, logistics) often benefit from recourse agreements.
When to Choose Non-Recourse Factoring
Non-recourse factoring is ideal if:
Your Customers Are High-Risk:
If your customers have poor credit or operate in volatile industries, non-recourse factoring can provide peace of mind.
You Want to Mitigate Risk:
Protecting your business from insolvency-related losses can outweigh the higher costs.
Common Questions
Does non-recourse factoring cover all risks?
Non-recourse agreements usually only cover customer insolvency. Disputes over products, services, or delivery terms are still the business’s responsibility.
Is recourse factoring too risky for most businesses?
For businesses with reliable customers, recourse factoring is a cost-effective option with minimal risk. Most factoring agreements in the United States are recourse factoring.
Does non-recourse factoring always cost more?
While non-recourse agreements generally have higher fees, the added protection can save businesses significant money in the event of customer insolvency.
How to Decide Which Option is Right for You
1. Assess Your Customer Base
Do your customers have a strong history of paying on time? Recourse factoring may be sufficient. Are you dealing with new or high-risk customers that are likely to go out of business? Consider non-recourse factoring for added protection.
2. Consider Your Industry
Stable industries with predictable cash flows are better suited to recourse agreements. High-risk industries may benefit more from non-recourse factoring.
3. Evaluate Your Risk Tolerance
Are you comfortable assuming responsibility for unpaid invoices? Recourse factoring can save money. Do you prefer to offload risk entirely? Non-recourse factoring provides peace of mind, but still may not provide all the protection you’re hoping for.
4. Compare Costs
Calculate the total costs of each option, including fees and potential losses due to unpaid invoices.
Recourse vs Non-Recourse: Choosing the Right Type of Factoring
Choosing between recourse and non-recourse factoring depends on your business’s unique needs, customer base, and risk tolerance. Recourse factoring is a cost-effective option for businesses with reliable customers, while non-recourse factoring offers some added protection for those dealing with clients and industries where insolvency is a high risk.
Both options can significantly improve cash flow, enabling businesses to operate more efficiently and seize growth opportunities. Understanding the key differences and evaluating your circumstances will ensure you choose the best solution for your business.
If you’re ready to explore factoring or need help deciding which option is right for you, contact us to discuss your business’s needs and goals. We’re here to help you keep your cash flow moving and your business growing.