Regardless of industry, invoice factoring can be a highly valuable tool to help companies get quick access to the capital they need to run their business effectively. But while you may be broadly aware of what invoice factoring is, it’s important to familiarize yourself with the different types before getting started.
There are two primary types of factoring that businesses need to know: recourse and non-recourse factoring. There are several differences between the two, and knowing those differences can help you decide which approach is best for your business needs.
Below, we’ll explain what those differences are so you can make an informed decision on which option is best suited for your business.
What is Recourse Factoring?
Recourse factoring is a financial agreement between a factoring company and an individual business where the business assumes responsibility for non-payment. Between the two primary factoring types, recourse factoring is more common.
To give an example, let’s say your business wants to start factoring its invoices. You research different factoring companies and find a preferred partner that specializes in recourse factoring, so you agree to their terms. The factoring company buys your invoice at a discounted rate and your business receives a cash advance, with the rest of your money coming once the customer pays.
But what happens if the customer doesn’t pay? In this case, your business is responsible for the debt and the factoring company has the right to recourse. This means that you will have to buy back any invoices where the factoring company is unable to collect payment.
To be clear, the factoring company you work with should be doing everything it can to collect the payment for you – and reputable companies will help underwrite the credit risk to ensure you’re working with the right broker. However, even brokers with strong reputations can experience problems or make mistakes that result in financial consequences for you and your business.
What is Non-Recourse Factoring?
While recourse factoring involves individual businesses assuming the risk of non-payment from customers, non-recourse factoring is where the factoring company does so instead.
However, it’s less common for factoring companies to offer this as an option. And even if they do, that doesn’t mean your business is completely protected from risk. In fact, many non-recourse factoring agreements come with stipulations and only cover very specific situations.
For instance, some factoring companies will offer non-recourse factoring as an option but only when your customer closes their business or declares bankruptcy. Others won’t offer it as an option unless your debtors have a credit rating that meets their standard. This would mean that you assume the risk of non-payment for your customers that have poor credit history.
These stipulations will vary based on the factoring company you work with. As you can see, however, there are reasons why non-recourse factoring is less common and may not be the right choice for certain companies.
Recourse vs. Non-Recourse Factoring: Which is Best for You?
While there are similarities between recourse and non-recourse factoring, it’s important to understand the key differences between the two. To recap, the main difference between recourse and non-recourse factoring is who assumes the risk of non-payment. In recourse factoring, you are responsible for repurchasing unpaid invoices, making it less expensive but riskier. In non-recourse factoring, the factoring company assumes the risk of non-payment, offering more protection for you but at higher fees. Businesses should review agreements carefully, as non-recourse terms may only cover specific situations like bankruptcy.
Each option has pros and cons that your business will need to consider, and it’s important to give an honest assessment of your current financial situation, your risk tolerance and the trustworthiness of your customers to make an informed decision. Remember though, the most important things you can do to keep your company protected are:
- Work with customers who have strong creditworthiness with consistent payment histories.
- Partner with a reputable factoring company that is committed to helping you through the process and, if necessary, making a diligent effort to ensure collection on your invoices.