Payroll financing for small businesses, explained

A business can be profitable on paper and still come up short on payday. Customers may pay invoices weeks after the work is done, a season may be slow, or a burst of hiring may push payroll costs ahead of revenue. Payroll financing is the general name for funding used to bridge that gap.

The phrase is used loosely. Some providers market a product as a “payroll loan,” but underneath it may be a term loan, a line of credit, invoice factoring or a sales-based advance. Knowing which one is being offered matters, because each has a different cost structure, repayment schedule and legal form.

Some payroll service providers also offer funding to their customers. Terms vary, so they deserve the same scrutiny as any other offer. Our pages on working capital loans and business lines of credit explain those two forms in more detail.

In each form, money arrives before payroll and is repaid later from receivables, sales or fixed installments. The difference is in the details:

• Loans and lines of credit are usually repaid in fixed installments on a set schedule.
• With factoring, repayment happens when customers pay the invoices the factor bought.
• With sales-based financing, the provider collects from the business’s deposits, often by daily or weekly debit.

Payment frequency matters as much as price. Daily or weekly debits take cash out of the account before the next payroll comes around, which can make the original problem harder, not easier.

When a business runs payroll, it generally has to withhold certain taxes from employees’ wages, pay the employer’s share of some taxes, deposit them with the IRS on schedule and file regular returns. The IRS explains these duties in its guide to understanding employment taxes (opens in a new tab).

Those duties do not change because payroll is tight. Any plan that funds net paychecks by delaying tax deposits creates a new and serious problem with the IRS. Talk with a tax professional or payroll provider if deposits are at risk. BizKindly does not give tax advice.

• Payroll history and payroll reports.
• Business bank statements.
• An accounts receivable aging report, for factoring or invoice financing.
• How long the business has been operating, and its revenue.
• Personal credit, business credit, or both.

Providers weigh these differently. Factors often focus on the creditworthiness of the business’s customers, while lenders focus more on the business and its owners. Our guide to getting loan-ready covers the common documents.

Because these products describe cost in different ways, the most reliable comparison is the total amount repaid and how often payments come out. For each offer, ask for:

• The total repayment amount, in dollars, compared with the amount received.
• The APR for a loan or line, the factor rate for sales-based financing, or the discount fee for factoring.
• The payment frequency: daily, weekly or monthly.
• Origination, processing or other fees.
• What happens if the business pays early.

Some states, including California and New York, require certain providers of commercial financing to give standardized disclosures, which can help when comparing. See the California DFPI (opens in a new tab) and New York law (opens in a new tab) for what those disclosures include.

• Advice to delay or skip payroll tax deposits.
• Daily debits that are larger than the business’s daily cash flow can support.
• No clear statement of the total amount to be repaid.
• Pressure to sign quickly because payday is close.

Questions to ask a provider:

1. What is the total repayment amount?
2. How often are payments collected, and how?
3. Is this a loan, factoring, or sales-based financing?
4. What disclosures does my state require for this product?
5. What happens if sales slow down or customers pay late?

A one-time gap, such as a large customer paying late, is different from coming up short every month. If gaps repeat, financing may only delay the problem. It can help to review pricing, payment terms with customers, and the timing of expenses, using the SBA’s guidance on managing your finances (opens in a new tab) and our cash flow guide.

SBA resource partners, including SCORE, Small Business Development Centers, Women’s Business Centers and Veterans Business Outreach Centers, offer free or low-cost counseling on cash flow and financing. Find one through the SBA’s resource partners page (opens in a new tab). The SBA’s loans overview (opens in a new tab) and the Federal Reserve’s Small Business Credit Survey (opens in a new tab) give more background on small business financing.