The Pros and Cons of Invoice Factoring in Tech Services Cashflow Management

Cash flow management can be one of the most painful subjects for freelancers and entrepreneurs in a small business, and it's a subject that's often poorly understood. Business owners often lack the language to have a productive conversation around the topic of cash flow finance, yet it's vital to long-term sustainability. It's not uncommon for tech companies to have significant revenue and terrible cash flow management.

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Invoice factoring companies can seem very attractive for small business owners facing unpaid invoices and cash flow problems. But is trading your invoices for immediate cash the best solution for your financing needs? The simple answer is, perhaps, but the equation is often complicated. But before we dive into the pros and cons of invoice factoring, let's first discuss common cashflow issues and effective ways to mitigate them.

Five Common Business Cash Flow Challenges:

1. Late-paying customers and outstanding invoices
2. Sick employees
3. New employee training time
4. Spending valuable time and working capital chasing what might go wrong
5. Bookkeeping errors

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As a proactive entrepreneur, there's a temptation to solve each of these cash flow problems personally. But for business owners in the first three years of business, trying to prevent these problems with your own time and energy versus having a solid cash management game plan in place is usually counterproductive. A healthy cash flow allows you to manage those same problems with extra money in the bank—and it's the difference between night and day when it comes down to what you're able to do when running a company. 

Are You Charging Enough?

There's a lot of merit to staying out of an overwhelmed state for a business owner and staying in the groove of being able to operate your business' momentum. Solid leadership looks like focusing on what's going right and maximizing that instead of the ten things that are mediocre. Getting your business in a cash position with so much margin that you can afford employee sickness and training times, late payments, and bookkeeping errors. All of these mistakes add up and can easily bankrupt a business. 

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There's a single way to get ahead of that: charging enough and maintaining low overhead. 

If three things go wrong in a single week for most small businesses, they're in trouble. There's a certain tension in facing one fire at a time, knowing you can't handle two or three at once. The business owner ends up serving that one issue for months or years when raising prices could have solved the same problem. 

If, for example, in-house training isn't good enough, what if raising prices would allow a company to hire someone better? Or what if the cost of required courses for new employees to take before they start with you was covered up-front? There are a lot of issues that cash fixes if properly applied, but when you're in a competitive marketplace, the temptation is to win on service, price, and uniqueness. 

Know When to Outsource

Being well-rounded is necessary in the technical services space–no business operator likes delivering bad news to clients. Having the cash in your bank account allows you to say, "We're not that good at that, but we can farm it out to someone who is," takes your no, or your, "We'll do that, but we don't know how yet," and turns it into a strong yes. It keeps you going. A healthy cash flow allows business owners to use capital to pay outside vendors to do things they're not good at.

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I run a software services company and, for us, SEO has a limited depth in our company. We have some incredible contract partners that we pull in when we need the next level of SEO. I can't afford to pay someone in-house to keep up with the latest SEO strategies in 2022, and it changes so fast that the training I paid for last year is now void. It would be best if you had someone whose full-time focus is to be a true expert, and they need to be better than average in their space. 

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I have dozens of friends running small businesses with under 50 employees, and I know what stresses the average operator or entrepreneur startup leader. They are all very capable of doing many things, which is why they're in the leadership positions they're in. But entrepreneurs must realize that they simply shouldn't do it all. Establishing basic boundaries when it comes to what's right outside of your company's skill set, and having the available cash to outsource those tasks, can make or break the long-term viability of a company.

Scaling Cashflow Management

If I'm running a business that makes $500,000 a month or $50,000 a month and I'm spending ninety percent of that, we all know there's a vast scale difference. If I only have a $10,000 buffer, I should hold onto it and put it into savings. I'm going to have $10,000 mistakes come up this year, and I will need that buffer. But if I have a $50,000 margin, I probably have enough cash to buy the required expertise if I get in a pickle. I can purchase redundancy if a project needs redundancy. I can buy accelerated training or marketing. Perhaps we'll need to invest in a marketing push or a salesman. Even though both companies run on ninety percent margins, the cash flow management looks very different.

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What's important isn't knowing your margins by percentage; it's knowing your freed-up cash that's stabilized and predictable. It's important to ask, is it reasonable to operate with enough money to have choices next month or next quarter when you hit a speed bump? Can speed bumps be solved by deploying a trusted team member with freed-up cash versus the business owner having to take their eyes off the road and be distracted? That shift in focus can be costly when operators find themselves driving a significant endeavor, and they're likely to wreck when they've taken their eyes off of what they're good at.

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Having a network of contractors you're talking to that helps you solve those problems requires margin. Building a network that acts as an extension of your company or your product takes time. You have to buy time with money, which comes down to deploying capital wisely.

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Let's say you invent something, and you've ordered this product that people really like, and you're shipping it out to pre-ordered customers. If one thing goes wrong in that first run, your product reviews will tank. If you sell a universal remote control that your customers have been dying for, yet one crucial button doesn't quite work, you've wasted $100K on manufacturing this sweet universal remote. Now all of your reviews and all of your customer faith have tanked. It doesn't matter how beautifully you've nailed the packaging or how amazing your video is–you're tanked. Now you need another $100K to fix that. And then you need time. Now, if you have $250K available, you can fix what's gone wrong, and your chances of being business five years from now are so much higher. 

Testing the Price Ceiling

The hardest lesson in my career has been recognizing that I can fix many things myself, but I need staying power to do that. To be sustainable as a business leader, I have to buy myself time. I can't be the solution to every unknown. I have to have me plus cash. I have to be able to say, "Maybe I COULD solve that problem, but I'm definitely not the BEST person to do that." If I have some cash on hand, I can hire or manage the right person to solve that problem; that will allow me to thrive for a couple of decades in a business. 

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You need to be able to absorb the unknowns. That means two things:

1) Charging enough to your customers 

2) Testing the ceilings of your rates

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We're currently priced in the lower middle in our industry, and I know that that's not healthy enough. I know that in 2022 I need to do a meaningful price increase because of the unknowns we're navigating with COVID, technology demands, and increasingly competitive hiring. I'm nervous about what our customers will say. It will add more pressure, but that's mostly a facade. I haven't yet asked them or tested rate increases. In some sense, it doesn't matter because the true cost of business does incorporate the future. You have to know, I'm going to run this business for another year, and some things will go wrong; I have to have the cash flow for that now. 

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Testing the price ceiling is the hardest thing to overcome psychologically. Detaching yourself from the ego of your value proposition and saying, "We're going to see what the market is willing to pay. If there's a ceiling on it that makes this business unsustainable, then I'm going to sell a different product or service. The market has spoken." But if you don't know that the market has spoken, then you're not testing enough.

Is Lending Part of a Healthy Business?

In my opinion, lending is always a part of a healthy growing business. However, taking on debt in a company that's still very much in the testing phase isn't always the best choice. Don't try to operate with debt on something unproven.

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The health of any company must be defined as a sustainable growing business. If you know your business well, you know there are ups and downs. Lending decisions come down to basic margin theory. If I can only make nine dollars from a borrowed $100K, then I'm probably not running a good business, or I'm the wrong person to run it, or my customers are the wrong customers. 

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It's crucial to be in an industry where you know there are plenty of other customers out there, and given another twenty-four months, you'll out-compete a nine percent interest rate because you have so many tools at your disposal. You can hire, create, and upsell to existing consumers–there are many different levers to choose from. But, yes, I do think that business loans are an important part of operating a business. 

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With COVID, the government made available some very cheap money for most types of businesses. I believe that most sustainable companies are making good use of that. If we're talking about borrowing from credit cards, on the other hand, I see that as bad debt in nearly every case. Twenty-five percent interest is going to be challenging to fight up against. Invoice financing companies may provide a solution for technical services companies who need quick cash.

What is Invoice Factoring?

For those who don't know what invoice factoring is, it's essentially borrowing against an invoice amount generated by a reputable customer. A business operator or accounts receivable department sends unpaid invoices to a factoring company; then, the originating company gets paid on the value of the invoices from the lender. The factoring agreement requires that the lender take cash off the top in exchange for collecting customer payments. 

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In my opinion, invoice factoring is a lending tool that's worth considering for stabilized growing businesses where time is more important than money. But, as with all business financing options, there are advantages and disadvantages of factoring.

Invoice Factoring as a Business Financing Solution

The first time I ran into invoice factoring, I was brokering in the consumer product space. We had a boutique business that would advise on how startups could get consumer products into mass-market retail stores such as Costco, CVS, Walgreens, Rite Aid, and Target. We constantly spoke with business founders about the first purchase orders they'd receive from a large retailer, which felt exciting but also came with its challenges.

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Say, for example, you have the best stick of gum that the world's ever seen, and it needs to be placed at 50,000 stores in the US. CVS isn't going to buy one pack of gum; they're going to buy a couple of cases of gum multiplied by 5,000 stores. This initial purchase order fulfills a moment in which you have almost all of your eggs in one basket, which can be nerve-wracking.

Retailers Won't Pay Until the Product Sells Through 

Once your product hits the shelves, retailers won't know if it will sell through until customers pick it up–or not. This initial waiting game means that retailers are refusing to pay vendors for usually the first ninety days. Opting for invoice factoring in this situation is risky because you're factoring an unproven product at what will likely be insane interest rates. 

If it's not your first time launching into 5,000 stores and you've done that for three straight years, and you're operating a business in six mass-market retailers, the situation is different. Suppose you have a good online footprint, and you're not just trying to scrape the money together to get enough product to sell. In that case, you can absolutely leverage lower rate invoicing factoring to speed up that ninety-day timeframe to get paid now. In this case, working with invoice factoring companies allows you to spend your cash on hiring employees or pushing out marketing to sell a proven product.

Pros and Cons of Factoring Invoices

Lending is often a way for technical service companies to make it. There are really good scenarios to do it in when it comes to invoice factoring, and there are really nasty ones. 

Advantages of Invoice Factoring

     • Factoring services offer quick cash.

Invoice factoring provides relief from short-term cash flow shortages. If you're in that sixty- or ninety-day waiting period between when you send out an invoice and when you get paid, cash can quickly become thin for new tech startups. Invoice factoring could be your best bet if fast cash is what you need.

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     • Invoice factoring doesn't require a credit check.

Factoring companies offer options for business owners with a tainted credit history or a lack of equity to offer as collateral. The only collateral required is in the form of unpaid invoices on delivered work to reputable customers. 

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     • Factoring allows you to offer payment terms to your clients.

Offering your buyers extended payment terms on invoices can be stretching for many small businesses, and the waiting period can prove to be unsustainable for companies operating on tight margins. When factoring companies assume your invoices, you get paid quickly no matter how long it takes the client to deliver on their accounts.

Disadvantages of Invoice Factoring

     • Factoring services assume ownership of your invoices.

Instead of you being the one to communicate directly with your clients, they'll be hearing from an employee of your invoice factoring company, a company that they have no relationship with. For some business owners, this change of hands may come as a relief; for others, the disconnect can feel uncomfortable when dealing with customer issues or late payments.

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     • Finance companies aren't collection agencies.

An unfortunate aspect of business ownership is dealing with bad debt. And while an invoice factoring company will pursue payment from your clients, there is no guarantee of payment. Invoices that go unpaid for extended periods will ultimately end with you. At the end of the day, those unpaid invoices will be passed along to your collections agency.

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     • Invoice financing rates don't offer stabilized lending. 

Here's an example of three-percent invoice factoring. Factoring companies will give you $10K for an invoice the same day. When they get paid on that invoice, they'll keep three hundred dollars. The more invoices you have, they'll just keep funding those for you and always accelerate that cash. 

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What people who are new to the invoice factoring game don't see at first blush is, in that $10K example, they are re-lending you the same $10K over and over. If you do that all year long, a monthly ritual, the cost of factoring is over thirty percent interest on that $10K. It's not even legal to charge that much interest, but they can because they don't count it as interest. In the long run, this results in a steep factoring fee.

Invoice Factoring: The Bottom Line

The truth of the matter is that the tech services industry is a competitive space. With the majority of tech startups failing in this day and age, achieving sustainability requires grit, a healthy cash flow, and creative problem-solving. For some, invoice factoring can play a part in helping a small business stay afloat.

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The bottom line is this: borrowing isn't infinite. Creditworthiness has to be there–you have to be squeaky clean to get good bank loans and lines of credit. Not everyone has a credit score that allows them to get those traditional loans. If that's you, the cost of factoring may be worth the price, even if only as a temporary solution.