Payroll funding: What is it, and when should you use it?

Accurately compensating your employees on time — month after month — can strain even the most organized of companies. Things change, outside factors occur, and mistakes can be made, whether you’re a fledgling startup or an established multinational.

This is why it’s crucial to understand payroll funding, and the pros and cons of using it as a cash flow solution.

In this article, we’ll explain the nuances of payroll funding, and help you learn how to use this financial tool effectively. So let’s jump straight in.

What are payroll funds?

Payroll funds are the pool of financial resources that a business allocates specifically for paying its employees. This includes salaries, wages, bonuses, and any other forms of compensation owed to employees. 

However, companies sometimes don’t have enough liquid funds on hand to meet their payroll obligations for a given period. This might be because of seasonal sales fluctuations, rapid growth, or temporary financial constraints due to delayed revenue streams.

This is where payroll funding comes in. 

What is payroll funding?

Payroll funding — also known as payroll financing or payroll loans — is a financial service that gives businesses the capital they need to cover their payroll expenses. Through these loans or advances, your employees can still be paid without delay, even in times of restricted cash flow. 

This financial mechanism gives businesses the flexibility to meet their salary obligations without compromising their operational integrity. It is particularly useful for small businesses, which often struggle with cash flow gaps. 

Is payroll funding right for your business?

Payroll funding might be right for your business if you experience temporary cash flow problems that threaten your ability to meet your payroll obligations. It’s ideal for companies with strong receivables but delayed payment terms, or those in growth phases that need a steady, consistent cash flow.

It’s not advisable to rely long term on payroll funding.

How does payroll funding work?

To obtain payroll funding, you typically apply for it from a lender, who then evaluates your company's financial health, creditworthiness, and the predictability of its revenue streams. 

If approved, the lender then extends a loan or advance that specifically covers your payroll expenses.

The steps to obtain payroll funding

1. Apply for funding. This usually involves providing detailed financial information, including cash flow statements, payroll records, and business forecasts.

2. Assessment. As with other loans, the lender assesses your application based on your company’s financial stability, credit history, and how reliable its regular income streams are. This evaluation determines not only the likelihood of getting approved but also the terms of the loan.

3. Approval. If approved, the lender and the borrower review and agree upon the terms of the loan, including the interest rates, the repayment schedule, and the funding amount.

4. Receive funds. Following approval, the funds are made available to your company — often within a few days — so that it can meet its payroll deadlines.

Types of loans available

There are several different types of payroll funding available. Some of the most common include:

1. Short-term business loans

With a short-term loan, your company requests a one-time lump sum from a payroll funding provider that must be repaid within a short time frame (usually less than a year). 

These business loans are designed to address immediate, short-term financial needs, such as emergency repairs, occasional insufficient payroll funds, or quick-turnaround inventory purchases. 

Due to the shorter repayment period and the increased risk to the lender, the interest rates on these loans are generally higher. As a result, businesses often need to meet minimum credit score criteria to qualify for one. Lenders may also require proof of stable or increasing revenue streams, so that the business can handle the repayment within the short term.

2. Business lines of credit 

Unlike a lump sum loan, a line of credit at a bank provides your company with access to funds up to a certain limit. Conveniently, your company only pays interest on the loan amount it actually uses, which often results in lower costs than taking out a short-term loan.

To be eligible, the bank may require your business to have been operational for a specific period, usually of at least one year.

Depending on the size of the line of credit, lenders may also require collateral to secure it. This collateral can include business assets, inventory, or receivables.

3. Invoice financing 

With invoice financing, your business uses its outstanding invoices as collateral to borrow immediate cash from a lender. You submit your unpaid invoices to a financing company, which then typically advances you a significant percentage of the invoice value (often 80% to 90%). 

After your customer settles the invoice, you receive the remaining balance minus a predetermined fee that the financing service charges for providing the advance.

Some lenders require a business to have operated for a minimum amount of time — often six months to a year — to prove it has a viable track record.

Businesses may also need to show a certain level of annual revenue or a steady income flow to qualify. In addition, lenders often assess the creditworthiness of the clients who owe on the invoices, since their ability to pay directly affects the repayment of the financed amount.

What is the payroll funding rate?

The payroll funding rate varies by lender and is influenced by the company's creditworthiness, financial health, and the terms of the funding. Note that, in addition to interest rates, there are usually additional fees related to the cost of borrowing the funds.

In general, though, most lenders typically offer a percentage of your company’s average payroll expenses (or the value of the invoices being financed).

For payroll funding, lenders may offer a cash advance percentage ranging from 80% to 100% of the payroll amount needed, depending on their risk assessment.

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Benefits of payroll funding

Payroll funding is a strategic financial solution that has some helpful benefits for business operations, including:

Better cash flow management

One of the biggest advantages of payroll funding is the improvement in cash flow management. By accessing these funds, you can bridge the gap between your immediate payroll obligations and your incoming revenues. This allows you to meet your operational expenses without compromising on paying your employees on time.

A positive impact on employee morale 

One of the hardest things a business has to deal with when running out of cash is employees finding out that the company isn’t able to pay their salaries. This shock can have a serious impact on employee trust and morale. 

Payroll funding is a great way to circumvent this problem and prevent employees from losing faith in the organization’s financial stability.

More flexibility in financial management

Payroll funding offers companies increased flexibility in managing their finances, helping them maneuver through seasonal dips in revenue or manage unexpected expenses. It allows companies to adapt quickly to changing financial circumstances without the added stress of worrying about their payroll obligations.

A financial buffer

Payroll funding can serve as a buffer for businesses to maintain their credit standing by avoiding late payments to creditors. It also frees up capital that can be invested in other areas of the business to drive growth and innovation.

Drawbacks of payroll funding

Payroll funding also comes with some drawbacks, which are important to consider before making use of this financial instrument. These include:

Reduced profit margins

A primary concern with payroll funding is the potential reduction in profit margins. This occurs because the cost of this type of funding (in the form of interest rates or fees) directly impacts the bottom line. 

The financial burden of payroll funding could potentially cause new cash flow problems, especially for companies that already operate on thin margins.

Extra costs

Though payroll funding sounds attractive, it often comes with extra costs that can catch businesses off guard. 

Beyond the interest rates, there are often origination fees, processing fees, and sometimes penalties for early repayment or not meeting the terms of the funding agreement. These additional fees can accumulate quickly and make the true cost of funding much higher than you may have initially anticipated.

Dependency on external funds

Another big drawback of payroll funding is that it can create a dependency on outside sources. 

Relying too much on lenders to meet payroll could be a symptom of deeper financial problems in a company. Over time, this reliance can make it difficult or even impossible for a business to build up the internal cash reserves it needs to become financially healthy. This makes the company more vulnerable to financial fluctuations and less capable of embracing growth opportunities when they present themselves.

Reduced creditworthiness

Finally, frequent use of payroll funding can impact your company's creditworthiness. If lenders perceive the business as overly reliant on funding, that may lead to higher interest rates for future borrowing or make it challenging to secure future loans.

Best practices for payroll funding 

If payroll funding is the right option for your business, here are some essential best practices and tips for minimizing the risks:

• Regularly review your company’s financial statements so that you’re clear about your ability to repay the funding.

• Research traditional and online lenders carefully to find reputable ones with favorable terms and a track record of reliability.

• Only borrow the amount you need to cover payroll expenses. This helps to avoid unnecessary debt.

• Before accepting any funding, make sure you fully understand the interest rates, fees, and repayment terms.

• Develop a clear, strategic repayment plan that aligns with your business’s cash flow projections.

• Keep an open line of communication with your payroll finance company, especially if you anticipate challenges with repayment.

• Use the funding strictly for payroll to avoid complicating your financial situation.

• Work consistently on improving your cash flow, including reducing operational expenses, to avoid turning external funding into a habit.

If you follow these practices, payroll funding can be a beneficial cash flow instrument rather than a financial burden.

Avoiding payroll funding with Remote 

Payroll funding is a useful way out in times of cash flow problems, but it’s always preferable to avoid it in the first place. One way to do this is by investing in a reliable payroll solution, like Remote.

By automating your payroll, you free up your finance team to keep a closer eye on any potential cash flow problems, as well as external factors that might cause such issues in the future. Remote’s local, on-the-ground experts can also help you plan your payroll management more effectively and strategically.

To learn more about how we can handle the heavy payroll lifting, speak to one of our friendly experts today.

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