Invoice factoring: What it is and how it works

Invoice factoring is one of the oldest ways businesses have financed their operations. Instead of waiting weeks or months for customers to pay, a company can sell its accounts receivable (its unpaid invoices) to a factoring company at a discount. The business receives most of the invoice value right away, and once the customer pays, the factoring company forwards the remaining balance after fees.

For founders, the appeal is easy to see. Extended payment terms and outstanding invoices can create cash flow gaps that make payroll stressful, delay supplier payments, and slow down growth. By converting invoices into immediate working capital, factoring can provide breathing room when liquidity is tight.

But factoring also comes with tradeoffs. It is not a loan, and it doesn’t always require a strong business credit score, since factoring companies focus more on customer creditworthiness. Still, the fees reduce margins, and turning collections over to a third party can affect customer relationships. Most arrangements are also recourse, meaning you may still be on the hook if a customer doesn’t pay.

This guide explores how invoice factoring works in practice, what it costs, and why small businesses and startups sometimes use it. We’ll also dig into the risks, compare factoring with other financing options, and show how modern alternatives can offer founders a faster, more flexible path to non-dilutive funding designed for long-term growth.

What is invoice factoring?

Invoice factoring is the practice of selling your accounts receivable to a third party at a discount in exchange for immediate cash. Instead of waiting through long payment terms, your business can convert invoices into working capital and use that money to cover operating needs today.

Depending on the context, you may also hear invoice factoring called accounts receivable factoring or debt factoring. These all mean the same thing, and their structure is straightforward: the factoring company buys the right to collect your customer payments, advances you a percentage of the invoice value up front, and then forwards you the remainder (minus fees) once your customer pays in full.

For founders, the core appeal is speed. If you’ve issued $50,000 in invoices to reliable customers but cash isn’t due for another 60 days, a factoring company may advance you 80-90% of the total amount within a few business days. Once the customer pays, you’ll receive the balance that’s left over after the factoring fee.

That infusion can help bridge short-term cash flow gaps. Payroll, rent, inventory purchases, and supplier payments don’t wait on net-60 or net-90 cycles, and factoring can keep those obligations covered. For many small businesses and early-stage startups, it feels like a simple solution.

But the simplicity masks tradeoffs. The discount reduces the total you collect from each invoice, which cuts into margins. And because the factoring company steps into the middle of your customer relationship, you lose some control over how collections are managed. Most agreements are also structured as recourse, meaning you remain responsible if the customer fails to pay.

Factoring can be a practical bridge when liquidity is tight, but it is rarely a long-term financing solution for growing companies.

How does invoice factoring work?

At its core, invoice factoring is a simple exchange: you hand over unpaid invoices, and in return, you get cash up front. But the process itself follows a predictable set of steps that every founder should understand before signing an agreement.

Step 1: Submit invoices

You choose which outstanding invoices to factor and send them to a factoring provider (typically, one of these companies) for review.

Step 2: Eligibility review

The factoring company evaluates your customer’s creditworthiness and payment history. Unlike a bank loan, approval often depends less on your credit score and more on whether your customers are likely to pay on time.

Step 3: Cash advance

Once approved, the factoring company issues an upfront payment. This advance is usually 80–90% of the total invoice value and can arrive in just a few business days.

Step 4: Collections

The factoring company becomes responsible for collecting payment directly from your customers. At this point, the invoice is off your balance sheet.

Step 5: Remaining balance

When your customer pays in full, the factoring company sends you the rest of the invoice amount, subtracting its factoring fee and any additional charges.

An example of factoring in practice

Say your startup has $25,000 in unpaid invoices. A factoring company offers to advance 85%, with a 3% factoring fee.

• Invoice value: $25,000

• Advance upfront: $21,250

• Factoring fee: $750 (3% of invoice amount)

• Remaining balance after collection: $3,000 – $750 = $2,250

• Total received: $23,500

In this case, you secure immediate cash to cover expenses but give up $1,500 in revenue. For a startup operating with thin margins, those tradeoffs compound quickly as more invoices are factored.

The process is efficient, but it’s important to recognize what’s happening under the hood: you’re exchanging a portion of your future income for liquidity today, with the factoring company managing the timing, collections, and fees in between.

Types of invoice factoring

Not all factoring agreements look the same. The structure you choose shapes the cost, the risk you take on, and how much control you retain over your customer relationships. 

Founders considering this route should understand the three primary forms:

1 - Recourse factoring

This is the most common arrangement. You receive an upfront advance on your invoices, but if your customer doesn’t pay, you’re responsible for reimbursing the factoring provider. Because you carry that risk, fees are lower than other forms of factoring. For early-stage businesses, the appeal is affordability, but the downside is clear: you’re still exposed to bad debt. If a major client defaults, the liability falls back on you.

2 - Non-recourse factoring

Here, the factoring company assumes responsibility if a customer fails to pay. On the surface, this feels safer, since your startup is shielded from non-payment risk. 

In practice, though, the protection comes at a price. Fees are higher, and factoring providers tend to be more selective, approving only invoices tied to customers with strong credit histories. That means access can be limited, and the cost can quickly erode your margins.

3 - Invoice discounting (a form of invoice financing)

This structure is closer to invoice financing—which we’ll cover in the next section—than true factoring. Instead of selling your invoices outright, you borrow against them. Your invoices serve as collateral, and you remain responsible for collecting payments. 

While this lets you keep customer relationships intact, you carry both the repayment obligation and the collections burden, which can strain internal resources.

A quick comparison of the types

As you can see, each of these approaches comes with its own tradeoffs.

• Recourse factoring lowers fees but leaves you liable for non-payment. 

• Non-recourse factoring reduces liability but cuts into revenue with higher costs. 

• Invoice discounting keeps control in your hands, but doesn’t solve the underlying pressure of chasing down customer payments. 

For founders, the decision often comes down to what matters more: minimizing cost, limiting risk, or maintaining customer trust.

Invoice factoring vs. invoice financing

Both factoring and financing allow you to turn unpaid invoices into cash, but the mechanics and tradeoffs are different. Understanding the distinction will help you decide which option fits your business needs.

Invoice factoring

With factoring, you sell your invoices outright to a third-party company. They advance you a portion of the invoice value up front (typically 80-90%) and then take over responsibility for collecting payment from your customers. Once your customer pays, the factoring provider forwards the remaining balance, minus their fee.

The advantage here is speed: you can unlock cash quickly without waiting through long payment terms. But there are downsides. The fees can be steep, and you lose control of the collections process, which may affect how customers experience your business.

Invoice financing

Financing works differently. Instead of selling invoices, you use them as collateral for a loan or line of credit. Your customers still pay you directly, and you remain responsible for repaying the lender once the invoices are settled.

This keeps the customer relationship in your hands, which many founders prefer. However, it also introduces repayment obligations and interest costs. You gain more control than with factoring, but at the cost of carrying debt and managing repayment alongside collections.

For founders, the distinction comes down to control versus convenience. Factoring shifts responsibility to the financing company and gets cash into your account quickly, but it reduces margins and risks putting collections in someone else’s hands. Financing preserves your customer relationships, but you carry the repayment obligation and the burden of managing both collections and debt service.

Neither approach is inherently better; both are short-term tools to bridge cash flow gaps. But for startups planning to scale, the recurring costs of either can become restrictive. At that point, founders often look toward alternatives, like venture debt or a flexible line of credit, that are designed for longer-term business financing needs.

Factoring cost and fees explained

Most factoring companies charge 1–5% of the invoice amount per month. That may not sound excessive, but when annualized, the effective cost can rival or exceed high-interest credit cards. A fee of 3% per month translates to an annualized rate of more than 36%; far higher than what you’d see with a bank loan or even a business line of credit.

The base fee is only part of the story. Many factoring agreements layer on additional charges that quickly add up:

• Origination fees for setting up the agreement.

• Credit checks on your customers, often billed back to you.

• Monthly minimums that require a certain volume of invoices to be factored.

• Service or processing fees for each transaction.

For a founder trying to stretch runway, factoring costs can reshape the economics of every sale. A 3% fee on a $100,000 invoice may not feel painful once, but if multiple invoices are factored month after month, you’re effectively handing over a meaningful share of your gross margin just to accelerate cash flow.

Another cost to weigh is the impact on customer relationships, since factoring companies—not you—manage collections.

For startups, the calculus comes down to this: does the benefit of cash in hand outweigh the compounding costs over time? If not, there are alternatives, like venture debt, working capital facilities, and flexible credit lines, that don’t carry the steep fees or loss of customer control that factoring creates.

Why small businesses and startups use invoice factoring

Even with the costs, many small businesses and startups continue to rely on invoice factoring. The draw comes down to speed and accessibility at moments when liquidity is tight.

Improved cash flow

The most immediate benefit is improved cash flow. Payroll, rent, and vendor invoices arrive on a fixed schedule, while customer payments often do not. Factoring provides a way to bridge that mismatch. For an early-stage company without a large cash buffer, converting receivables into working capital can mean the difference between keeping operations moving and missing critical obligations.

Keeps the balance sheet clean

Another reason founders consider factoring is that it typically does not create new debt on the balance sheet, depending on the structure of the agreement. Since invoices are sold rather than borrowed against, it can avoid adding a traditional business loan or line of credit liability.

Ease of approval

Approval is also easier to secure compared with many traditional financing options. Banks typically underwrite against a company’s operating history, credit score, and collateral. Factoring companies, by contrast, focus on the creditworthiness of your customers. That makes invoice factoring accessible even for startups with thin or imperfect credit histories, provided their clients have a track record of paying.

Meeting short-term funding needs

Finally, invoice factoring can meet short-term funding needs, from purchasing inventory ahead of a seasonal spike to covering an unexpected equipment repair or funding a marketing push before a product launch. Because factoring companies can advance cash within a few business days, it often feels faster and less burdensome than waiting on a bank loan.

For founders facing urgent expenses, those advantages are compelling. Yet it’s important to recognize that factoring is designed as a stopgap solution, not a long-term strategy for sustainable growth. The speed comes at a cost, and the tradeoffs become clearer the more frequently you use it.

Drawbacks and risks of invoice factoring

While invoice factoring can provide quick relief, the downsides are significant, especially for startups focused on scaling.

The cost of factoring

The most obvious drawback is cost. Factoring fees often exceed the effective rate of a bank loan, a line of credit, or even revenue-based financing. A 3% fee may not seem alarming, but when compounded regularly, it can erode margins and limit reinvestment in growth. For founders already balancing thin unit economics, this expense can be hard to justify over time.

Loss of control

There’s also the loss of control to consider. Once invoices are sold, the factoring company steps in to manage collections. How they interact with your customers is out of your hands. If the approach feels aggressive or impersonal, it can weaken the trust you’ve worked to build. For early-stage startups that rely on strong customer relationships and referrals, this hidden cost can be just as damaging as the financial one.

Ongoing liability

With recourse factoring, you also carry ongoing liability. If a customer fails to pay, the obligation falls back to you. That risk can be manageable with a diversified client base, but if a single large customer defaults, it can create serious financial strain.

Poor business model fit

Finally, factoring isn’t a fit for every business model. SaaS and consumer-facing startups rarely issue invoices large enough or structured in the right way to qualify. Even in industries where invoices are common, factoring companies may impose eligibility requirements around invoice volume, payment terms, or customer creditworthiness that exclude younger businesses.

For many scaling startups, these risks outweigh the short-term benefits. What looks like a quick fix can end up reducing margins, straining customer relationships, and introducing liabilities at the exact stage when stability matters most.

Invoice factoring vs. other financing options

Factoring is just one form of financing available to founders, but it’s far from the only one. Bank loans, business credit cards, and lines of credit have long been standard tools for managing cash flow. More recently, revenue-based financing and venture debt have become popular among startups looking for non-dilutive capital designed for growth. Each option comes with its own balance of cost, eligibility requirements, and flexibility. 

For founders, the decision often comes down to long-term scalability. Invoice factoring can bridge a short-term gap, but financing solutions like venture debt or lines of credit are typically more cost-effective and flexible.

Financing growth beyond invoice factoring

Invoice factoring can provide quick cash flow, but it’s not built for scaling companies. The high costs, loss of customer control, and ongoing liability make it a short-term bridge at best.

For founders focused on long-term growth, other non-dilutive financing solutions, like as venture debt, revenue-based financing, and flexible lines of credit, often provide more sustainable capital structures. These options support working capital needs while giving you greater control over costs, customer relationships, and repayment terms.

At Rho, we help founders build financial infrastructure that scales with their company. Our platform combines banking, treasury, and financing solutions in one place, so you can compare funding options, manage cash flow, and prepare for the next raise with confidence.

Get started with Rho today, and find the right financing structure to fund what’s next.

FAQs about invoice factoring

What is the difference between invoice factoring and accounts receivable financing?

Invoice factoring involves selling invoices, while accounts receivable financing means borrowing against them.

Is invoice factoring considered debt?

Not necessarily. When invoices are sold without recourse, the transaction may be treated as a sale and may not appear as debt, but certain factoring arrangements—especially those with recourse—can still create balance-sheet liabilities

How much does invoice factoring cost on average?

Factoring fees typically range from 1% to 5% of the invoice amount per month, plus additional fees.

Do startups need a good credit score to use invoice factoring?

Not usually. Factoring companies look more at your customers’ creditworthiness than your business credit.

What are the types of invoice factoring agreements?

The main types are recourse factoring, non-recourse factoring, and invoice discounting.

How quickly can a business get funding through invoice factoring?

Most factoring companies can advance cash within 2–7 days after you submit invoices. The exact timing depends on your customers’ creditworthiness and the specific factoring agreement.

Does invoice factoring affect my customers?

Yes. Since the factoring company takes over collections, your customers may be contacted directly about payments. This can change how your customers experience the relationship, depending on the factoring provider’s approach.

What industries use invoice factoring the most?

Invoice factoring is common in industries with long payment cycles, such as manufacturing, wholesale, staffing, and transportation. SaaS and direct-to-consumer startups often aren’t a fit because they don’t rely on traditional invoicing.

How is invoice factoring different from a business loan or line of credit?

Invoice factoring does not add debt to your balance sheet—you’re selling invoices for immediate cash. Loans and lines of credit create debt obligations but are often less expensive over time and let you retain control over customer collections.