Differences Between a Term Loan and Factoring

  • By The Able Team
  • Published 10/26/2016

There are many types of financing that are available to growing B2B businesses which need to obtain more funding. The most common types of financing include small business loans from banks and alternative lenders (term loans), as well as a financing solution referred to as invoice factoring.

To better make an informed decision as to which type of financing might be the best option for your company, you should first understand the differences between a term loan and invoice factoring, and why small business loans may not always be your best option.

What Is Invoice Factoring? Receivables Financing?

To start with, invoice factoring and receivables financing are mostly used interchangeably in practice, but they’re different in theory.

Invoice factoring is the sale of accounts receivables at a discount. Receivables financing, by contract, is a loan against the value of invoices as collateral.

So when we say invoice factoring, we mean the sale of receivables in return for the cash upfront.

The major benefit of factoring is the ability to unlock reserves of cash that hadn’t otherwise been paid out to your company yet, and as your company grows and more invoices are available, so does potential funding. This means that invoice factoring can grow with your business.

Additionally, you can receive cash without taking on more debt or affecting your credit profile, and factoring companies often work with businesses of all sizes.

So Why Factor?

Factoring solves the big problems of most B2B suppliers and service providers: big clients have the clout to set payment terms. Typically, this means you provide your goods and services on day 1, but don’t get paid until day 30, 60, 90, or even day 120 (“Net 30”, “Net 60, “Net 90”, “Net 120”), which creates a huge cash crunch.

Factoring helps smooth out this cash crunch because you can sell your net 60 invoices for money. But the trade-off is you get less overall, which creates longer-term cash flow issues.

Invoice Factoring Contrasted with Term Loans

Unlike invoice factoring, term loans are… loans. So they come with all the problems of loans:

  • Approval rates are lower, especially for banks
  • The application is more strenuous
  • The monthly payments tend to be less affordable
  • Non-bank lenders can be more flexible, but there’s a much wider variation in terms and rates

It can also take too long to ultimately receive approval and funding, and many businesses don’t relish the idea of adding more debt. Finally, there is little to no leverage for additional funding should the need arise for it.

Pros and Cons of Factoring

Factoring has the following benefits:

  • You can get approved for factoring in as little as 3-5 days
  • Approval is based upon how good your client’s credit is, not necessarily your own credit rating. This makes it ideal for earlier stage companies
  • There is potential for increased and continuous funding — factoring grows with your business
  • You can be eligible for factoring even if you have just started your business, so long as you have invoices

And the following cons:

  • Factoring isn’t covered by lending laws, which means the terms tend to be less favorable than proper loans
  • Factoring doesn’t have an APR (interest) but typically, you only receive 80 to 90 percent of the value of the invoice
  • Customers can be scared off by invoice factoring. Typically, factoring involves a lock-box, where your customers send payment directly to the factoring company
  • Factoring will grow with your company, but not beyond. You’ll always be limited to your invoices, which means it’s not a great tool for growing your business.

In short, factoring is a great cash-flow management tool. It’s not, however, a great tool for growing your business, because you need the invoices first.

So Why Use a Term Loan?

Unlike factoring, term loans are ideal for growth capital. If you need to expand your operation beyond what you’re currently doing (and beyond your current invoices), you’ll need to use a term loan (or similar financing agreement).

The big benefits include:

  • Affordability. Terms loans have longer terms, and therefore tend to be more affordable.
  • Cost of Capital. All in, term loans tend to be cheaper than factoring. The factoring rate (together with fees) tends to add up pretty quickly.
  • Loan Amount. This is the corollary of affordability. Because term loans are more affordable, you can afford to take out more (assuming you have the ability to repay).

Because of that, the two big situations when to use a term loan are (1) when you’re paying too much in factoring fees and it’s cheaper to use a term loan to “self-factor”, and (2) when you want to finance a larger, longer-term growth project.

What If You Can’t Get a Term Loan?

The biggest barrier to a long-term, low-rate loan is typically the difficulty of getting approved.

Earlier stage, higher growth companies in particular find themselves between a rock and a hard place.

They tend to get turned away by banks and most term lenders (who are looking for more stable, established customers), or steered towards factoring products.

And they can get higher rate, shorter term financing from lenders and cash advance companies, but these loans are harder to afford — especially without the stable cash flows of more established businesses.

At Able, we specialize in high-growth, earlier stage companies. That’s because backers help reduce our risk, which means we can offer bank-style loans to pre-bankable customers.

If you’re curious, you can quickly see how much funding you might qualify for without affecting your credit score. Good luck in your future business endeavors!

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