The short version
When you factor, you sell an invoice your business customer has not yet paid. The buyer, called the factor, sends you a large share of the invoice value within days. Your customer then pays the factor instead of you. When that payment arrives, the factor keeps its fee and sends you the rest.
The detail that matters is in how each step is documented, how the fee is calculated, and what happens when the customer pays late, short or not at all. If you run trucks, our guide to what freight factoring costs applies the same ideas to loads and brokers.
The three parties
Every factoring arrangement has three participants, and the contract will use specific names for each.
- The client (sometimes called the seller or assignor) is your business. You delivered goods or services and issued an invoice on credit terms.
- The factor (the purchaser or assignee) buys the invoice and takes over collection.
- The account debtor is your customer, the business that owes the invoice. The UCC uses this term, and so do most factoring agreements.
The most important thing to understand about this structure is whose credit counts. A factor is buying a promise to pay made by your customer, so it underwrites mainly the account debtor. A young business with thin financials can often factor invoices owed by large, reliable customers. An established business selling to slow or shaky customers may find factoring harder or more expensive than expected.
Factoring is a sale, and the law treats it that way
In a true factoring arrangement you are selling an asset, not borrowing against it. Article 9 of the Uniform Commercial Code, which every state has adopted in some form, covers both secured loans and outright sales of receivables. Section 9-109(a)(3) says the article applies to "a sale of accounts," so a factor perfects its ownership through the same filing system a lender would use.
Once the sale is complete, UCC 9-318(a) provides that a business that has sold an account does not keep a legal or equitable interest in it. In plain terms, the money your customer pays on a factored invoice belongs to the factor, not to you, even if it lands in your bank account by mistake. That rule sits behind the misdirected-payment clauses discussed in our guide on how to read a factoring contract.
The lifecycle of a factoring relationship
1. Application
You apply with basic company information, a list of customers you want to factor, and an accounts receivable aging report showing who owes what and for how long. Expect to supply sample invoices, proof of delivery and owner identification.
2. Due diligence
The factor checks three things. First, your customers' credit and payment history, because that is the risk it is buying. Second, whether anyone else already has a claim on your receivables, which it learns by searching the UCC filings in your state. Third, whether your invoices are real and complete: that the work was done, the customer accepted it, and nothing in the paperwork gives the customer an easy reason to refuse payment.
If a bank or another lender already has a lien on your receivables, the factor will usually require that lender to release or subordinate its claim before funding. Our factoring vs. line of credit guide covers how that negotiation works.
3. Signing and the UCC-1 filing
You sign a factoring or receivables purchase agreement, and the factor files a UCC-1 financing statement with the secretary of state where your business is organized. Under UCC 9-310(a), a financing statement must generally be filed to perfect a security interest, and that includes the interest a buyer of accounts holds. Under UCC 9-515(a), a filed financing statement is effective for five years unless continued.
Pay attention to what the filing covers. UCC 9-504 lets a financing statement describe the collateral either specifically or simply as "all assets." A factor that files against all assets has a public claim on far more than your invoices, which can complicate future equipment loans or bank credit.
4. Notice of assignment
The factor, or you on its behalf, sends each customer a notice that the invoices have been assigned and that payment must now go to the factor. This step does real legal work. Under UCC 9-406(a), a customer can discharge its debt by paying you until it receives an authenticated notice of assignment; once it has that notice, paying you no longer discharges the debt. The notice must reasonably identify what was assigned, and under 9-406(c) the customer can ask for reasonable proof that the assignment happened.
UCC 9-406(d) also makes most contract terms that prohibit or restrict assigning an account ineffective. A customer's no-assignment clause generally does not stop you from factoring its invoices.
5. Schedule of accounts
Each time you want funding, you submit a schedule of accounts: a list of the invoices you are selling, with copies of the invoices and supporting documents. The factor verifies some or all of them, sometimes by contacting the customer directly, and confirms they are within each customer's approved credit limit.
6. The advance
The factor pays you an advance, a percentage of the face value of the scheduled invoices, usually by ACH or wire. The rest is held back as a reserve. The reserve is not a fee. It is the factor's cushion against short payments, disputes and its own fee, and it comes back to you after the customer pays.
7. Collection
Your customer pays the factor on its normal terms, typically to a lockbox or account the factor controls. UCC 9-607(a)(1) gives a party with an interest in accounts the right to notify account debtors and collect from them directly, where the agreement allows it or after default. In a well-run arrangement your customer simply sees a new remittance address.
8. Rebate of the reserve
When payment arrives, the factor calculates its fee based on how long the invoice was outstanding, deducts it from the reserve along with any other agreed charges, and releases the remainder to you. That release is called the rebate. Some factors rebate each invoice as it is paid; others settle up weekly or monthly. The timing is a contract term worth negotiating.
A worked example
The numbers below are illustrative only. They are round figures chosen to show the arithmetic, not a quote or a market average. Actual advance rates and fees vary by industry, volume and customer credit.
Suppose your business invoices a customer $50,000 on net 45 terms. The factor offers an 85% advance and a fee of 2% for the first 30 days, plus 0.5% for each additional 10 days or part of 10 days.
| Step | Calculation | Amount |
|---|---|---|
| Invoice face value | $50,000 | |
| Advance paid to you (85%) | $50,000 x 85% | $42,500 |
| Reserve held back (15%) | $50,000 x 15% | $7,500 |
| Customer pays on day 42 | $50,000 | |
| Fee: first 30 days | $50,000 x 2.0% | $1,000 |
| Fee: days 31 to 42 (two 10-day blocks) | $50,000 x 0.5% x 2 | $500 |
| Total fee (3.0%) | $1,500 | |
| Rebate to you | $7,500 - $1,500 | $6,000 |
| Total you receive | $42,500 + $6,000 | $48,500 |
The check on the arithmetic: $50,000 face value minus the $1,500 fee is $48,500, which matches the advance plus the rebate.
Now change one thing. The customer disputes part of the order and pays only $48,000. Buying the invoice does not strip your customer of its complaints: under UCC 9-404(a), the factor's rights are generally subject to the terms of your contract with the customer and to defenses arising from the same transaction. The factor still earns its $1,500 fee, and the $2,000 short payment also comes out of the reserve. Your rebate falls to $7,500 - $1,500 - $2,000 = $4,000, and you receive $46,500 in total, which is $48,000 collected minus the $1,500 fee. If the shortfall had been larger than the reserve, the factor would look to you to make up the difference under most agreements. Our recourse vs. non-recourse guide explains when that obligation applies and when it does not.
To try your own numbers, including different advance rates and payment timing, use the factoring calculator.
Factoring vs. invoice financing and AR loans
The terms get used loosely, but the structures are different.
| Factoring | Invoice financing / AR loan | |
|---|---|---|
| What happens to the invoice | Sold to the factor | Pledged as collateral for a loan |
| Who collects | Usually the factor | Usually you |
| Does your customer know | Usually, through the notice of assignment | Often not |
| On your balance sheet | Receivable removed, cash received | Receivable stays, loan added |
| Main credit question | Your customers' ability to pay | Your ability to repay, plus collateral quality |
| Cost basis | Discount fee on each invoice | Interest on the outstanding balance, plus fees |
In practice the line blurs. Many factoring agreements give the factor the right to make you buy back unpaid invoices, which makes them behave a lot like loans, and some invoice financing programs collect directly from customers. What matters is what your contract says about who bears the loss, who controls collection and how the cost is calculated, whatever the product is called.
Spot factoring vs. whole-ledger factoring
Spot factoring, sometimes called single-invoice factoring, lets you sell individual invoices when you choose. It suits an occasional cash gap, but expect higher per-invoice pricing because each deal is set up separately.
Whole-ledger factoring means you agree to sell all, or all eligible, invoices to the factor for the contract term. Pricing is usually better because the volume is predictable, but you give up flexibility, and these contracts are more likely to carry monthly minimums, multi-month terms and early-exit fees. Between the two sit agreements that require you to factor all invoices from named customers but leave others out. If you only need occasional funding, a whole-ledger contract can cost you money in months you would rather not factor at all.
Notification vs. non-notification factoring
Notification factoring is the standard model described above: your customers are told about the assignment and pay the factor directly. It gives the factor the strongest legal position under UCC 9-406, which is why it usually costs less.
Non-notification factoring, sometimes called confidential factoring, keeps the arrangement out of your customers' view. They keep paying you, and you forward the payments to the factor, often through an account the factor controls. Because the factor cannot rely on the notice rule and must trust you to pass payments through, it is usually offered only to larger, financially stronger clients and priced accordingly. Most non-notification agreements let the factor switch to notification if it becomes concerned.
Who factoring suits
Factoring tends to work well when:
- You sell to other businesses or government agencies on terms of 30 days or more, and the waiting is the problem, not the customers.
- Your customers are more creditworthy than your business is on paper, perhaps because you are young, growing fast or recovering from a bad year.
- Growth is outrunning cash. Factoring capacity rises with sales, while a fixed bank line does not.
It tends to work poorly when:
- You sell to consumers. Factoring is built around business-to-business receivables.
- Your margins are thin. A fee of a few percent per invoice can consume most of the profit on low-margin work.
- Your invoices are often disputed, billed before the work is complete, or subject to retainage and back-charges. Many factors will not buy progress billings or contingent receivables.
- You qualify for a bank line of credit at a reasonable rate and can manage the borrowing base reporting. Our factoring vs. line of credit guide shows how to compare the two on an annualized basis.
Factors also specialize, and one that knows your industry's paperwork will usually verify faster and reject fewer invoices. You can browse factors by sector on our industries page.
Before you sign
Get the advance rate, the fee at 30, 60 and 90 days, the rebate timing, the scope of the UCC filing and the cost of leaving in writing. Our guide on how to read a factoring contract walks through the clauses where those answers live, and hidden fees in factoring covers the charges that do not appear in the headline rate.
Frequently asked questions
How fast does factoring pay?
The first funding takes longest because of due diligence, the UCC search and filing, and notifying your customers. After setup, most factors fund approved invoices within a day or two of receiving a complete schedule. Delays usually come from missing paperwork or invoices the factor cannot verify.
Will my customers know I am factoring?
In notification factoring, yes. They receive a notice of assignment and pay the factor. Most business customers are used to this, particularly in industries where factoring is common. Non-notification factoring keeps the arrangement confidential but is usually available only to larger businesses.
Is factoring a loan?
A true factoring arrangement is a sale of receivables, not a loan. The UCC covers both, which is why a factor files a UCC-1 just as a lender would. Agreements that give the factor broad rights to make you repurchase unpaid invoices shift a lot of the risk back to you, so read the recourse terms carefully.
What happens if my customer never pays?
It depends on whether your agreement is recourse or non-recourse, and on why the customer did not pay. Under recourse factoring you buy the invoice back or replace it. Under non-recourse, the factor usually absorbs the loss only for defined credit events such as bankruptcy. See our recourse vs. non-recourse guide.
Can I factor if my customer's contract forbids assignment?
Generally yes. UCC 9-406(d) makes most contract terms that prohibit or restrict the assignment of accounts ineffective. There are exceptions, and some government contracts follow separate federal rules, so confirm the position with the factor and, where the amount is significant, with a lawyer.