Factoring 101: Understanding the risk and rules
What is the difference between invoice factoring and a loan?
What really sets factoring apart is the way it’s structured. Instead of being treated like a traditional loan, factoring is actually a sale of an asset, the invoice itself. Factoring is not a loan but a purchase and sale between two parties. Think of it like this: a business that’s waiting on customer payments sells that invoice at a small discount in exchange for immediate cash.
In this setup, there are two key players. On one side, you have the Seller—the business that issues the invoice and needs quicker access to funds. On the other side, there’s the Buyer, the factoring company that purchases the invoice, takes on the responsibility of collecting payment, and provides the business with upfront working capital.
This structure makes factoring different from borrowing because the business isn’t taking on new debt. Instead, it’s simply turning a receivable into usable cash, which can help keep operations running smoothly without adding another liability to the balance sheet.
Once a factor reviews and approves the receivables it wants to buy, those invoices are expected to pay just like they normally would, typically within 90 days or less from the invoice date. As those payments come in, the factor frees up room for the business (the Seller) to sell more invoices. This cycle repeats over and over, turning outstanding invoices into immediate cash flow and keeping the Seller’s working capital fluid.
Why do factors collect payments directly?
A Notice of Assignment is simply a letter the factor sends to a client’s customer letting them know that the invoices have been sold and assigned. From that point forward, the customer is instructed to send all current and future payments directly to the factor, unless the factor later provides different instructions.
Usually, this notice goes straight to the accounts payable department, and here’s the key: it doesn’t need the customer’s sign-off or acknowledgement to be binding. Under the Uniform Commercial Code (Section 9-406a), if the customer pays anyone other than the factor, the debt isn’t considered paid off.
This process is essential because factoring isn’t a loan. Instead, the factor counts on receiving payments directly from the customers in order to make the arrangement work smoothly.
Do invoice factoring companies file a UCC-1?
When a lender has a stake in something you own, they usually make it public. Think of it like when there’s a lien on your car title or a mortgage on your home. It’s basically their way of saying, “This asset is tied up—if it’s sold, we need to be paid first.” You’ll grant them the right to file a UCC-1 in the Loan or Security Agreement documents.
A UCC-1 filing works much like a lien or mortgage, but for businesses. It’s recorded with the Secretary of State in the state where the business was formed. Most factoring companies file a UCC-1 as soon as the relationship begins.
Why? Because in order to purchase your invoices, a factor usually needs to be in “first position” on those accounts. If other lenders already have UCC filings in place (think bank or SBA loan), the factor will need to negotiate into that first position before moving forward. It’s a necessity in order to legally sell the invoices.
Sometimes a business has multiple lenders, each with a claim on the same collateral. If those other creditors agree, or if there’s some financial arrangement, the parties can sign what’s called a Subordination Agreement. This simply means everyone agrees that the invoice factoring company gets the top spot, or “superior position,” on the accounts being purchased.
When a business has several lenders involved, things can get tricky. In some cases, a factoring company may agree to a “carve-out” meaning other accounts are excluded from being factored. This usually happens when senior lenders don’t want to give up control of every account to the invoice factoring company.
When lenders work out a subordination agreement, it might not give the factor access to every account right away. That can limit how much funding you get upfront. But it’s usually just the first step. As trust builds between the lenders, more accounts can be freed up, which means more cash flow for your business.
What is better, recourse or non-recourse factoring?
When you look at invoice factoring, there are really two main types: recourse and non-recourse.
With recourse factoring, you’re still ultimately responsible if your customer doesn’t pay. For example, if you factor a $50,000 invoice and the customer goes out of business, you’ll need to buy that invoice back or replace it with another one of equal value. Think of it as: the factor advances you the cash, but the risk of non-payment stays with you.
With non-recourse factoring, the risk shifts more to the factor. As long as the customer qualifies for credit insurance, you’re protected if they can’t pay due to insolvency. For instance, if that same $50,000 customer went bankrupt, the factor would take the hit—not you. The catch is that “non-recourse” doesn’t cover every situation; if there’s a dispute about the product or service (say, the customer claims the order was wrong), you’re still responsible.
So, in simple terms:
• Recourse = safer for the factor, more responsibility on you. Less expensive for you.
• Non-recourse = safer for you, as long as your customer is insurable. More expensive and more restrictive on eligibility, which may affect cash flow.
Making a decision if recourse vs non-recourse is better should boil down to customer concentration.
Example:
Customer Concentration & Credit Exposure example for recourse vs non-recourse factoring:
Scenario | Sales Mix | Exposure Risk | Impact of a $75,000 Default |
High Concentration | $1,000,000 annual sales One customer = $300,000 (30%) | Heavy dependence on one client. If they fail, a large portion of revenue is at risk. | Losing $75,000 from this client = 25% of their business with you and 7.5% of your total sales gone immediately. |
Moderate Concentration | $1,000,000 annual sales Five customers = $200,000 each (20%) | Balanced but still vulnerable. Each client carries significant weight. | If one fails, you lose 7.5% of your total revenue right away. |
Well-Diversified | $1,000,000 annual sales 20 customers = $50,000 each (5%) | Risk is spread across many customers. A single default is less damaging. | Losing $75,000 (about 1.5 customers’ worth) = only 7.5% of revenue, easier to absorb. |
The recourse vs non-recourse factoring takeaway: The more spread out your customer base, the less devastating one failure can be. Factoring can help manage that risk, but understanding your concentration is the first step to determining between recourse or non-recourse factoring.
Make sure you read the fine print and really understand what non-recourse factoring truly offers.
1. Not every customer can be covered by credit insurance—it depends on their financial strength.
2. Even if they are insurable, the coverage might not fully match what they owe you.
3. A factor may only be willing to buy as much as the insurance company is willing to cover.
4. Credit insurance isn’t permanent—coverage can be reduced or withdrawn at any time.
5. Non-recourse factoring cost is 15 to 30 basis points higher for coverage.
6. And keep in mind: insurance won’t protect you if the customer simply refuses to pay or disputes the invoice—in that case, the invoice could still fall back on you under recourse.
Some factors give you the option of a hybrid recourse and non-recourse agreements. This setup lets the factor decide when to step in and cover certain customers, giving you more flexibility in how you manage risk.
You can also get your own trade credit protection through providers like Coface, Allianz, or Atradius. They offer coverage that works much like the protection you’d get from a factoring company.
Recourse vs. Non-Recourse Factoring Comparison
Feature
| Recourse Factoring
| Non-Recourse Factoring
|
Who takes the risk?
| You (the seller) are responsible if the customer doesn’t pay.
| The factor takes on the risk if the customer becomes insolvent (bankruptcy, liquidation) provided the customer is insurable.
|
Typical Cost
| Lower fees, since the factor has less risk.
| Higher fees, because the factor is assuming more risk.
|
When you repay
| If the invoice isn’t paid for any reason, you must repay or replace it. | You’re protected only if the customer is credit-insured and fails due to bankruptcy.
|
Disputed Invoices | You must resolve disputes and still repay if necessary.
| Still your responsibility—disputes are not covered under non-recourse.
|
Best For | Businesses confident in their customers’ ability to pay. | Businesses that want added protection from customer bankruptcies, insolvency or high concentration.
|
Example Scenario | Customer refuses to pay or goes out of business → You repay the factor. | Customer goes bankrupt but was insured → Factor absorbs the loss, you keep the advance. |
What happens when an invoice is disputed?
Invoice disputes pop up all the time, and in factoring, they can put stress on the relationship, especially if the disputes are big or happen often. That’s why factors don’t advance the full invoice amount upfront.
By holding a portion back, they make sure the discount fee is covered and there’s a buffer for any shortfall in payment. In the factoring world, this is known as dilution or an offset. Dilution can be managed when it’s expected, but an offset usually comes as a surprise.
Let’s cover dilution first.
Experienced factors who understand your industry know what’s reasonable when it comes to advance rates. They can strike the right balance between giving you cash up-front and protecting both sides against dilution.
If dilution is common in your industry, factors are usually ready for it. But when unexpected dilution shows up, it can catch them off guard and often impact funding until the issue gets cleared up. To stay within the agreed formula, factors lean heavily on the cash reserve account.
When a factor knows that significant dilution is on the horizon, they typically take two steps:
• Hold back cash reserve releases to build a balance that can absorb the dilution.
• Offset with new fundings—though this is really just pushing the problem forward, since it’s essentially a journal entry to plug the gap.
Most dilution factors see comes from suppliers into big box retail but it can be tucked into any supplier agreement.
Common Retailer Discounts & Deductions:
Category | Type | Typical Range / Notes |
Trade & Promo Discounts | Volume / bulk order discount | 1–5% depending on purchase size |
Promotional allowances (slotting, end-caps, features) | 5–15% of invoice or flat per-store/per-SKU fee | |
Co-op advertising / marketing | 2–10% of sales tied to campaigns | |
Payment Discounts | Early payment (e.g., 2/10, net 30) | 1–3% standard |
Cash settlement discounts | 1–2% if paid immediately | |
Compliance & Operational Deductions | Chargebacks (labeling, EDI, delivery errors) | $25–$150 per violation, sometimes % of invoice |
Freight allowances | 2–6% if supplier covers transport | |
Returns/defect allowances | 2–5% (can be higher in perishables) | |
Post-Sale Adjustments | Markdown allowances | 5–20% depending on clearance strategy |
Shrinkage / theft allowance | 1–3% standard in retail contracts | |
Guaranteed sales / consignment | Supplier absorbs unsold goods (varies widely) | |
Other Offsets | Slotting fees | $5K–$25K per SKU, sometimes higher in big-box |
Rebates / retroactive discounts | 2–10% based on sales volume achieved |
Key Takeaway: Between trade allowances, compliance chargebacks, and post-sale adjustments, suppliers may see 5–20% dilution of invoice value in major retail channels. This is exactly why factors calculate advance rates conservatively and why suppliers need to carefully manage deductions.
When there’s known dilution, factors use a simple formula to figure out the advance rate: they take two times the dilution and then add five percent on top.
Advance Rate Formula with Known Dilution Example
Item | Value |
Invoice Amount | $100,000 |
Known Dilution | 7.5% |
Formula Calculation | (7.5% × 2) = 15% + 5% = 20% Accured Reserve Holdback |
Advance Rate | 100% − 20% = 80% |
Advance Amount | $100,000 × 80% = $80,00 |
Let’s now discuss offsets.
Dilution is something you can plan for, but offsets are a different story. Offsets are those short-payments or non-payments that come out of left field. Just when the factor is expecting the customer’s payment to arrive as usual, a call or email shows up saying otherwise. What makes it even tougher is that sometimes the client already knew there was an issue with the payment but didn’t share it with the factor, which only adds to the surprise.
Factoring companies know that dilution and offsets are part of the business. What really matters is how openly clients communicate when an issue comes up. When clients are upfront about a problem, it shows good faith and gives both sides the chance to work together on a practical solution that keeps the relationship honest.
What if my customer does not pay my factor?
When a factor buys an invoice and that invoice doesn’t get paid, the factor looks at the reason for the non-payment and puts it into one of two buckets: non-payment due to insolvency (the customer can’t pay because they’ve gone bankrupt or shut down) or non-payment due to a dispute (the customer is refusing to pay because of an issue with the goods or services).
If your customer does not pay the factor, this is where your agreement with the factor, recourse or non-recourse, really matters.
· Recourse factoring: If you’re in a recourse arrangement, you’re ultimately responsible for repayment no matter what. If an invoice goes unpaid for any reason, the obligation comes back to you.
· Non-recourse factoring: With non-recourse, the factor takes on the risk if your customer becomes insolvent. But here’s the fine print—non-recourse usually has limitations. For example, it often only applies if the customer was covered by credit insurance, and even then, the coverage depends on the approved exposure limits.
One important thing to remember: disputes are always your responsibility. If your customer claims the invoice is wrong, incomplete, or tied to a service or product issue, the factor won’t absorb that loss. It’s still on you to make the factor whole.
Marc Marin is a seasoned expert in business financing, author, speaker, and educator with over 20 years of experience helping companies access working capital through factoring and funding solutions. He is known for making complex financial topics clear and actionable for business owners and finance professionals.