Startups need working capital. You’ve probably heard the staggering statistic that 90% of startups fail. However, what’s even more telling is that, of the small businesses that fail, 82% fail because of cash flow.
If you’re here, you’re likely a business owner wrestling with liquidity. Often, fixed startup costs, along with ongoing expenses like rent, payroll, and technology, (not to mention product development) come before you see any revenue. This drains your cash reserves. But if you’re here, you know the problem. We won’t waste your time laying it all out again.
At Flexent, we believe that accounts receivable factoring is a great tool for startups to stabilize their cash flow.
Factoring is a financial arrangement whereby a business sells its accounts receivable to a factoring company at a discount in exchange for immediate cash. Instead of waiting 30, 60, or even 120 days for customers to pay, a startup can receive payment the day they invoice. This removes liquidity bottlenecks, allowing you to focus on growing and establishing your company.
Accounts receivable factoring doesn’t require you to relinquish any ownership and can often have more lenient credit standards compared with traditional debt, making it a great option for startups.
If you’d like to learn more details about factoring and how it could help your business, read on. But if you’ve read enough, reach out to us—we’d love to have a conversation to see if factoring would be a good fit.
Unfortunately, if you are running a startup and looking for seed money, this article isn’t for you. There are other options out there, such as angel investors, crowdfunding, etc, but this article specifically covers working capital for startups.
The Working Capital Challenge for Startups
Getting a business off the ground is challenging. There are incorporation and legal fees, and depending on the complexity, licensing, equipment and professional services costs, staff, potentially even inventory. On top of all that, you may be developing a product, be that a physical product, a software, a service, or even an entire business model. These are steep challenges, but assuming a startup can gather enough momentum to get off the ground, the focus then turns to working capital and whether the startup can maintain the momentum and establish itself in the marketplace.
Maintaining momentum requires positive cash flow to meet payroll, fulfill orders, pay vendors, potentially pay rent, and other recurring costs. When taxes come around, that’s just another drain on liquidity. Depending on your industry, or whether you’re B2B or B2C, your startup may generate positive cash flow immediately. A landscaping company, for example, must purchase equipment and materials, but once the work begins, revenue follows shortly thereafter.
But what if you’re a staffing agency or a trucking startup? What if you’re providing products or services to the government or other large, slow-paying customers? In these scenarios, you’ve paid all your upfront costs to start the business, and then you have to pay to fulfill the contract for your customer. Fulfillment costs, depending on your industry, may include personnel, materials, inventory, transportation, etc.
Cash Flow & Slow-Paying Customers
Costs aren’t always simple, however. An order or project may take a day to fulfill—it may take a month. Once you invoice, the payment terms may be net 30 days after the completion or delivery—they may be net 60. At that point, you’ve laid out a lot of cash, and your cash conversion cycle could be 60 days or more. Perhaps you have enough cash on hand to wait, but what if you land another project, or another order comes in? Can you support another outlay of cash?
Perhaps you can, and so you start the new project, but then your first customer delays payment. Your time splits between servicing the new customer, chasing down payment from the previous customer, all the while juggling day-to-day expenses. The cash conversion cycle extends from 60, to 90, to 120 days. The second project may suffer delays because of this, and perhaps another customer enters the pipeline.
Learn more about dealing with slow paying customers: Slow Paying Customers: Fixing Cash Flow with Factoring
Working Capital & High Growth Startups
What makes things even more challenging is that successful startups often grow relatively quickly—sometimes exponentially. Growing from $10K/month in sales in January to $100K/month in June is a 10x growth rate over six months. That trajectory is unsustainable, but if a fraction of that growth rate continues until December, you could go from $100K/month to $300K/month. Driving a car takes fuel, driving a business takes cash. The larger the engine, the more it takes to keep it running. This creates a dire need for liquidity, or else you may need to stop taking on customers.
Learn more about working capital for high growth companies: Business Growing Too Fast? Financing Growth with Factoring
The Limitations of Traditional Financing Options
Unless venture capital is involved, startups will often turn to their local bank after expending their own resources. While this can work, there are some limitations to consider.
Banks often analyze past performance when lending out money. Since startups can go from 0 to 60 within a few months, their past performance is not a good indicator of their current cash flow needs.
Additionally, banks often require two years of tax returns. Some startups may not have two years of existence, let alone tax returns. For banks, this increases their risk—a business without history may not have the staying power to pay back a loan. Increased risk leads to increased rates, or denial. If a business has real estate, or hard assets, they may have a better shot, but many startups begin as ideas in a garage, or around a kitchen table—there may not be any hard assets.
This often leads small business owners to dip into their personal assets, leveraging their home with a HELOC, for example. This gets the job done, but puts your house on the line if the business doesn’t perform.
Equity Investing for Startups
You could also consider equity investors, but this option can be inflexible and more expensive in the long run. Suppose your valuation is currently $500K, and you need $100K of working capital. This could require you to give up 20% of your business for a fixed amount of cash. That influx of cash may meet your needs now, but as your business grows, your working capital needs are likely to grow as well. A year down the line, your valuation could increase to $2M, and you may need $500K in working capital, but you may still be unqualified for a bank loan, and you’ve already given up 20% (now $400K) of the business—that’s a heavy cost.
How Accounts Receivable Factoring Works for Startups
Accounts receivable factoring can be an invaluable working capital solution for startups. Although it may not work in every situation, and can’t serve as seed money to get the startup off the ground, it can keep startups moving, help them grow into established brands.
Factoring, as mentioned above, is a financial tool whereby a startup sells its B2B accounts receivable to a factoring company. The factor will often advance 80-90% of the invoice value upfront, holding the rest in reserve. Your customer remits payment to the factor, who then releases the reserve, minus their processing fee (often around 1-6%). So, at the end of the day, your business speeds up cash flow, and receives 94-99% of their invoice’s value.
Instead of waiting months for payment, a startup can get paid within 24-48 hours—sometimes even the same day.
To learn more about factoring, check out: What is Factoring? The Ultimate Guide to Business Invoice Financing
Benefits of Factoring for Startups
The most immediate benefit of AR factoring for startups is quick working capital. Factoring aligns contract completion with payment collection. You can receive payment the day you issue an invoice after performing a service or delivering a product. No more waiting, chasing down customers, or putting off rent to purchase inventory.
Since factoring is not a loan, but the sale of a financial asset, a startup will not incur traditional debt by using factoring. Factoring doesn’t require a business to give up ownership either—it’s the sale of accounts receivable, not the sale of equity.
Once you sell the receivable, your customer becomes responsible for remitting payment directly to the factor. Since the customer is responsible for repayment, underwriting depends less on your business’ history, and more on the credibility of your customers. This makes factoring an excellent choice for startups who work with larger customers and don’t have much credit history themselves.
Lastly, factoring is a flexible source of working capital, so long as you have commercial accounts receivable. The more receivables you generate, the more you can sell to a factor, and thus, the more cash you can pour back into your business. This allows factoring to scale as your business does—if your receivables jump from $100K to $500K to $5M, your factoring facility can as well (so long as your customers remain creditworthy).
Common Questions Startups Ask About Factoring
Common questions or concerns we come across when serving startups with factoring is how the arrangement will affect their customers. Often, factoring companies will reach out to your customers to verify the validity of the invoices and send out notices of assignment, instructing the customers to remit payment to the factoring company. This ensures that the factor is purchasing a valid receivable rather than bad debt, and that they will receive the payment. Some factors take over collections, but this is not always the case.
Many consider factoring to be the loan of last resort, which causes them to be wary of using factoring, because of the impact on customer perception. While factoring can be a last resort, it is not necessarily a last resort. In fact, well-established companies like Coca-Cola have used factoring, and it can be an invaluable tool for high-growth companies. Startups can us these facts to assure customers that factoring is a strategic move to focus less on AR management, and more on the business itself.
Another concern startups may have is factoring’s reputation for being expensive. Once again, this can be the case, but the picture is more nuanced. Factoring is often less costly than equity investors in the long run, and more flexible than traditional debt. In fact, factoring costs are comparable to accepting credit card payments, especially if you’re working with a bank owned factoring company. It comes down to cost and benefit. If you were paid the day you invoiced your customer, could you generate more business? If so, the benefits likely outweigh the costs.
Consider checking out our Accounts Receivable Carrying Cost calculator: Accounts Receivable Carrying Cost
When Factoring May Be Right for a Startup
Factoring does not work for every situation. A startup must have B2B or government accounts receivable. Otherwise, there is nothing to factor. Because of regulations, consumer receivables require additional notifications to be factored, and because of the complexity of contracts in the construction industry, construction receivables require additional paperwork and oversight. But if you are a startup with commercial AR, it’s probably worth a conversation.
