Legal Definitions - factoring

Factoring is a financial transaction where a business sells its outstanding invoices (money owed to it by customers) to a third-party financial company, known as a "factor," at a discount. In return for this immediate payment, the factor takes on the responsibility and risk of collecting the full amount from the original customers.

This process provides businesses with immediate cash flow, rather than waiting for customers to pay their invoices, which can often take 30, 60, or even 90 days. The factor profits from the difference between the discounted price paid for the invoices and the full amount ultimately collected from the customers.

• Example 1: Small Manufacturing Business

  A small custom furniture manufacturer, "WoodCraft Designs," lands a large order from a corporate client to furnish a new office building. The invoice for this project is for $100,000, with payment terms of 60 days. WoodCraft Designs needs to purchase expensive raw materials and pay its skilled carpenters immediately to start production on other orders. Instead of waiting two months for the corporate client to pay, WoodCraft Designs sells the $100,000 invoice to a factoring company for $95,000. WoodCraft Designs receives $95,000 almost immediately, allowing them to fund their operations. The factoring company then assumes the responsibility of collecting the full $100,000 from the corporate client when the invoice is due.

  This illustrates factoring because WoodCraft Designs exchanged a future payment (the $100,000 invoice) for immediate cash ($95,000), accepting a discount to accelerate their cash flow and transfer the risk of collection to the factor.

• Example 2: Tech Startup with Subscription Services

  "CloudSolutions," a new software-as-a-service (SaaS) startup, offers annual subscriptions to its business clients. They have successfully onboarded several large clients, generating invoices totaling $250,000 due over the next 90 days. However, CloudSolutions needs immediate capital to hire more developers and expand its marketing efforts. They decide to factor these outstanding subscription invoices. A factoring company purchases these invoices for $230,000. CloudSolutions receives the $230,000 upfront, which they use to invest in growth. The factoring company then manages the collection of the $250,000 from CloudSolutions' clients as their subscription payments become due.

  This example demonstrates factoring as CloudSolutions leveraged its future revenue stream (subscription invoices) to secure immediate working capital at a discounted rate, enabling faster business expansion while offloading the administrative burden and risk of collecting payments.

• Example 3: Construction Subcontractor

  "BuildRight Plumbing," a plumbing subcontractor, completes a major phase of work on a large commercial construction project and submits an invoice for $75,000 to the general contractor, with payment terms of 45 days. BuildRight Plumbing has immediate payroll obligations for its crew and needs to purchase specialized equipment for the next project. Waiting 45 days for the general contractor's payment would strain their finances. BuildRight Plumbing opts to factor this invoice, selling it to a factoring company for $70,000. They receive the funds within a few days, allowing them to meet their immediate expenses. The factoring company then collects the full $75,000 from the general contractor when the invoice is due.

  Here, factoring allowed BuildRight Plumbing to bridge a cash flow gap by converting a future payment into immediate funds, even at a discount, ensuring they could continue operations without interruption and transfer the risk of delayed payment from the general contractor to the factor.