What is factoring?
Factoring is a type of financial transaction where a company sells its account receivables to another party at a discount. Companies factor their accounts receivable or invoices when they need to access cash more quickly.
For example, a desk manufacturer called Desks R Us might have delivered large shipments—let's say $50,000 worth—of desks to five different companies. Each of those five companies would then owe Desks R Us $50,000, or $250,000 in total.
A problem might arise if Desks R Us wants or needs that money sooner than it is owed payments from its customers (now, for instance, rather than 30 days from now). In that instance, Desks R Us might sell its $250,000 in invoices to a third party for a slight discount.
Let's say the discount is 2%. In that transaction, Desks R Us would immediately get $245,000, or 98% of the full value of the invoices, and would transfer the accounts receivable to the purchaser. The purchaser of the invoices would thus have $250,000 in invoices that it could collect on. If the purchaser were able to collect the value of those invoices, it would make a $5,000 profit on this transaction.
So in factoring, the purchaser of invoices is willing to buy the invoices because it believes it can make money by collecting more for the invoices than it pays for them. It takes on counterparty and fraud risk in exchange for the opportunity to generate revenue.
How did factoring start, and how is it changing today?
The history of factoring extends back several thousand years, and, as the oldest form of trade finance, factoring's history is the history of international trade itself.
So factoring has been around almost as long as trade has been around, but today, the selling of invoices is beginning to go digital. The key challenges of factoring (which are managing the operational and fraud risk of invoices) are being handled in innovative ways by tech-forward companies like Denim, Marco and Mundi, which help companies access working capital by using software to bring together all phases of factoring into one system.
Given the $150 billion market size of factoring in the United States, as well as the success of early entrants in the space, you can expect to see a proliferation of factoring startups across all verticals, include healthcare and trade exporting, in the next several years.
What are some of the key reasons financial technology (fintech) companies are expanding into and winning the factoring space?
🔨 More access to fintech infrastructure for implementing money transfer capabilities. Factoring companies and startups need to have best-in-class infrastructure from Day 1 in order to get their customers money quickly. If they don't, they'll find it hard to ensure customer satisfaction and profitability. The proliferation of money movement APIs like Modern Treasury (which has a great guide to building an invoice factoring solution here) is part of a broader trend towards increased developer access to financial technology "building blocks," which drives down barriers to entry for new factoring startups.
🤖 Access to better models and tools for fraud and risk detection. Given the counterparty and operational risk involved in running a factoring business, factoring startups need to make sure they're only purchasing legitimate invoices. Similar to the point above on the rise of turnkey payment infrastructure, today's factoring entrepreneurs are able to leverage pre-built solutions not just for money movement, but also for fraud and risk detection. If money movement APIs are the highways that enable fast, programmatic transfer of funds, then identity verification and risk workflow solutions are like intermittent highway patrol checkpoints for ensuring that counterparties and invoices involved in factoring transactions are legitimate.
💻 Increased customer expectations for centralization, simplicity, and user-friendliness. In spaces from banking to travel, both individuals and businesses now expect to be able to conduct transactions online seamlessly and quickly. This is increasingly true in factoring as well, as customers looking for invoice factoring solutions are likely to value convenience and price transparency. From online onboarding, to faster approval, to better customer service, to transparency on terms, fintech factoring companies are able to offer customers convenience and speed.
Want to learn more?
Finley is debt capital management software that helps high-growth startups save time and money by automating routine credit facility management tasks like borrowing base reporting, verification, and alerting. Today, Finley manages over $2 billion in debt capital for high-growth startups like Ramp, Parafin, and Arc. If you're interested in learning more about software that can help you streamline your debt capital raise and management, just request a demo or take a self-guided product tour. We'd love to chat!