Waiting for unpaid invoices can take a substantial toll on your business and your employees. Not only does your business have less liquidity, but it also may not have the resources to pay staff on time. This can lead to layoffs, reduced hours, or delayed salaries. All of these consequences will only hurt your business in the long-run. When you can’t pay staff on time, it often decreases efficiency, reduces worker satisfaction, and greatly increases staff turnover. Thus, waiting on unpaid invoices can be much more expensive than most small business owners realize.
What can you do to ensure that your employees get paid on time, even when you’re waiting on overdue client payments? Fortunately, you have a few different options when it comes to increasing your short-term cash flow. Two common methods are invoice discounting and payroll funding. This begs a few important questions. Invoice discounting vs. payroll funding: what’s the difference? Is one option better than the other? Finally, how can you acquire the funding to pay your staff on time? We will answer all of these questions and more, but first, let’s look at what terms like “invoice discounting” and “payroll funding” actually mean.
If you want to take out a personal loan, you often have to provide proof of collateral to the lending institution. Once the lender knows that you have collateral, they will be more likely to issue the funds you need. Collateral reduces the risk for the lender by showing that, if you’re unable to pay back the loan in full, you still have property or assets that can be used to repay the debt. However, collateral isn’t just a factor in personal loans. It also plays an important role when borrowing funds for business expenses — including payroll.
If you want to secure funding from a financing company to pay for staffing costs, you may need to provide collateral. However, you might not want to overextend your business or take on too much risk by pledging assets that are vital to the integrity of your company. This is where invoice discounting comes in.
By definition, invoice discounting — often simply referred to as accounts receivable financing — is the practice of using unpaid invoices as collateral to secure an accounts receivable loan. This ensures that you can fulfill your payroll obligations by showing proof of future business income, thus securing AR financing. Invoice financing is one of the most common ways to increase short-term liquidity for businesses.
Invoice discounting essentially functions as a temporary boost to your cash flow business. Once you enter into an accounts receivable financing agreement with one or more invoice discounting companies, you will start receiving a portion of every client invoice from the lender. For example, let’s say that you invoice one of your clients for an amount of $6,000. Rather than waiting days, weeks, or even months to receive the payment in full, you will immediately receive 75% of the total amount, or $4,500, from your lender.
Though the payment process remains the same for your clients, it will look different on your end. Typically, the lender will manage incoming payments. So, when your client pays you, the invoice discounting company will manage the process and send the remaining amount to you — minus fees. The exact amount you pay will vary from company to company, but you can generally expect to pay anywhere between 2% and 5% to the lender from every invoice. To return to the example above, this would mean that — once all payments have been made and the fees accounted for — you will receive approximately $5,700 (depending on the terms of your agreement).
At first glance, invoice discounting looks similar to debt factoring. However, it’s important to take note of the difference between factoring and invoice discounting. As outlined above, invoice discounting involves unpaid invoices being paid in part by a lender in exchange for a fee. Debt factoring works much in the same way, though the lending company is usually charged with tracking down payment from the client.
For example, if you raise an invoice for $10,000, you will automatically receive a portion of it from the factoring company. In most cases, you will receive more than half upfront — though not the full amount. Then, the lender will actively seek payment from the client on your behalf. Once the payment has been secured, you will receive the remainder of the unpaid invoice, minus the factoring company’s fees.
The key difference between factoring and invoice discounting is the role of accounts receivable in the process. With invoice discounting, the unpaid invoices are simply used as collateral while the lender waits for payment from the client. Alternatively, a debt factoring company actually purchases the unpaid invoices from you, further incentivizing the company to chase down payment from your clients.
Payroll funding is a type of business loan that specifically targets payroll costs. Rather than selling off your outstanding accounts receivable (factoring) or using your invoices as collateral (invoice discounting), payroll funding offers a simple way to get cash quickly. You get a short-term cash loan with low monthly interest rates that vary based on the terms of your loan agreement. This way, you don’t have to keep track of every invoice as it relates to your loan. Instead, you can use the funds to pay your staff now and pay back the loan later on.
Therefore, the difference between invoice discounting and payroll funding is two-fold. First, the role of accounts receivable in payroll funding is very different from invoice discounting. You are not required to pay a percentage based on the volume of invoices with payroll funding; you simply pay for the funds that you borrow, for the length of time that you borrow them. Second, emergency payroll funding is specifically designed to help with immediate payroll costs. Rather than the funds provided by invoice discounting that can be broadly used for just about any business expense, payroll funding is specifically designed to pay staffing wages and the associated costs.
Finally, it’s important to take note of lower payroll funding costs. As previously stated, invoice discounting companies can charge anywhere from 2% and 5% on every unpaid invoice. Alternatively, payroll financing companies charge as little as 1.5% of the total loan amount per week, depending on the terms of the loan. As a result, payroll funding is usually the cheaper option, especially if you plan to pay off your loan quickly.
Payroll funding is one of the most efficient and cost-effective ways to secure liquidity and pay your staff on time. This way, you don’t have to feel the pressure of overdue invoices. You can simply apply for a loan agreement with a payroll funding company and get the funds you need now.
However, you will need to consider the requirements for a payroll funding loan. Since the fees are cheaper than most other types of business financing, the criteria for qualifying are also more stringent. This guarantees that only the companies that really need payroll funding and are better positioned to pay back the loan on time will receive funding.
There are dozens of different small business loans to choose from, but payroll funding is the best way to ensure that you can pay employees on time. If you can’t make payroll due to long wait times from clients, seasonal income fluctuations, or similar reasons, a payroll funding loan could be the best option for you. This will give you greater peace of mind and more power to run a successful business while you wait for client payments.
We hope you found this guide on invoice discounting vs. payroll funding useful! If you’re interested in learning more about the benefits of payroll funding, feel free to reach out to Payro Finance today!
Morris Reichman is the founder and CEO of Payro Finance. Former Vice President at Infinity Capital Funding an alternative finance company, Morris possesses a versatile background in the finance industry. Having spent 7+ years working across global macro operations and start up corporate finance Morris's expertise is in business accounting, risk management and investment analysis. Morris founded Payro Finance to support business owners and ensure their business continuity.