financeThis question made think about the idea of factoring.
My question is if, in general, the cash flow benefit of using a factoring service, such as Fundbox, is worth the fees paid to the service? For startups in particular?
Factoring services (and kissing cousins such as confidential invoice discounting, where your customer isn’t part of the loop) are all about funding day-to-day business operations where the cash flow isn’t in your favour. Let’s think of an example.
Suppose you’re setting up a website that lets companies offer their employees neck massages at their desks, booked via your site. You’ve found plenty of willing masseurs, and signed up some corporate customers. You’re making 50% gross margin and the business is growing strongly. So what’s the problem?
Well, it turns out that good masseurs have to be paid within a month, while even your friendliest customers have a habit of sitting on invoices for 90 days before they pay you. When NewCo signed up, in month 1 they ordered $500 worth of massages, in month 2 it was $2,500, month 3 was $5,000 and it’s looking like doubling again this month. Happy days!
Here’s how the cash flow goes.
Month 1 - you invoiced $500 and received $0; you were billed $250 and paid out $0. Net = $0
Month 2 - invoiced $2,500, received $0; billed $1,250, paid out $250. Net = -$250.
Month 3 - invoiced $5,000, received $0; billed $2,500, paid out $1,250. Net = -$1,250.
Next month - you expect to invoice $10,000 and receive $500; you expect to be billed $5,000 and pay out $2,500. Net = -$2,000. To date, you’ve paid out $3,500 net.
You’re profitable, but cash flow is killing you. So you sign across to someone else the full value of the invoices you’re sending out, and they give you (say) 80% of that value.
Doing that dropped your profit margin from 50% to 30%, which is painful. But it also transformed your cashflow.
Month 1 - invoice $500, collect $400; billed $250, paid $0. Net = +$400.
Month 2 - invoice $2,500, collect $2,000; billed $1,250, paid $250. Net = +$1,750.
Month 3 - invoice $5,000, collect $4,000; billed $2,500, paid $1,250. Net = +$2,750.
Month 4 - invoice $10,000, collect $8,000; billed $5,000, paid $2,500. Net = +$5,500.
In a startup, cash is almost always scarce, and it’s quite often the case that if you need money in a hurry, you’ll give up equity. It’s really painful to find that you’re smashing your targets, and losing a share in the business. And even worse to smash your targets and go bust.
So factoring and similar services can help you focus on growing the business as fast as you can.
However, most startups should read this situation as a sign that they need to improve their business model. In my imaginary case, I’d be looking hard for ways to make my customers happy to pay earlier, both by the obvious tack of negotiating with their finance team, but also by seeing if I could incorporate something so valuable (pre-emptive health reporting that could save the company money in the long run?) into the service that they would accept better (for me) payment terms. Don’t get comfortable with inherently bad cash flow!
But these services are valuable, and are too often overlooked. You just need to be aware of the three key costs/risks.
First, they’re typically expensive, compared to ordinary bank loans. In the exploration phase of a startup, you should be more worried about effectiveness than efficiency, but that doesn’t mean you should feel comfortable about handing over a large slice of the value you create every month.
Second, in traditional factoring (where you are essentially selling the invoice to a third party), there’s a reputation issue - as your customers can see that someone other than you is collecting the money.
Third, it’s very to get into trouble if business dips. In our scenario above, suppose we hit the holiday season and month 5 saw us invoicing $2,500. We’ll collect $2,000, but still have to pay out $5,000 to masseurs for services delivered last month. So there’s a lot of discipline required, because your business bank balance tells you an over-optimistic story.
Factoring gets badmouthed, but there are whole industries where it’s the norm. Startups need to understand the tools available to them, and use whatever works best. Only make sure you’re sufficiently financially literate to steer clear of the traps.
Given your question's only context is a reference to another question, I'll use that question as the context for this answer.
Taking a step back first, Fundbox is not a factoring service, this per Fundbox:
Fundbox offers a solution similar to factoring in some ways, but very different in others. As with factoring, Fundbox funds your outstanding invoices so you don't have to wait weeks or even months to get paid on a product already delivered or a service already provided. Unlike factoring solutions, Your clients are never a part of the loop. No sending checks to a new bank account and we never contact them. Creating a free account is super easy and takes less than a minute.
Fundbox appears to be more along the lines of a payday loan, though honestly, a quick review of their site leaves more questions than answers; meaning it is unclear who is underwriting the loan, how the loans are secured, etc.
Back to the context you've provided, in my opinion, eggyal's comment above best answers your question:
Depends on whether your cost of capital is greater or less than the interest/fees that they charge.
In the case of the question you referenced, it is unlikely that this business would benefit from factoring service given the scale of their business.
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