What Is a Debt Collection Agency, and When Do You Need One?

Most business owners who invoice customers for goods or services will encounter the occasional late payment. However, if a customer’s invoice due date has passed and you can’t get a firm answer on their payment status, it might be time to consider using a collection agency.

Here’s everything you need to know about debt collection agencies and how they might help your business get paid what it’s owed.

What is a collection agency?

A debt collection agency helps individuals or businesses recover unpaid debt, typically after an invoice is 90 days past due. The lender or creditor pays the agency a percentage of the amount successfully recovered, also known as a contingency fee.

For businesses, a collection agency uses databases to locate nonpaying customers and contacts them through written notices and phone calls to recover the money owed. The agency also provides updates on collection efforts and any settlements or payments received.

In some cases, a debt collection agency may file a lawsuit against a customer who cannot be reached or refuses to pay after several months of attempted contact. However, legal action is usually a last resort, and not all agencies are licensed or willing to pursue it.

Signs you may need to use a collection agency 

If any of these patterns sound familiar, a collection agency may be a good route for your business.

• Customer is unresponsive. Repeated unanswered calls or emails may signal avoidance.
• Invoices are over 90 days overdue. Older debts are harder to collect without professional help.
• Payments keep failing. Bounced checks or declined payments may indicate financial trouble.
• Excuses or delays continue. Ongoing complaints or postponements may be tactics to avoid paying.
• Cash flow is strained. Late payments can disrupt payroll and operations.
• Too much time is spent chasing payments. Debt collection shouldn’t distract from running your business.
• You want to protect the relationship. A third party can pursue payment while reducing tension.

If repeated efforts fail and unpaid accounts impact your business, it may be time to seek professional assistance.

[Read more: Cash Flow Killer: How Ignoring Your Accounts Payable Creates Hidden Costs]

How does a debt collection agency make money? 

Debt collection agencies typically earn revenue through several business models, depending on the services they provide and the accounts they manage. Common ways they make money include:

• Contingency fees: Agencies receive a percentage of the debt they successfully recover, often between 25% and 50%. Older or more difficult accounts generally carry higher commission rates.
• Debt purchasing: Some agencies buy delinquent debt for a fraction of its face value and keep any money they collect.
• Flat-fee arrangements: In some cases, creditors pay a fixed fee for collection services, regardless of whether the debt is recovered.

Types of collection agencies

Outside of internal collection departments (commonly known as first-party collection), there are three primary types of third-party collection agencies that may suit different business needs.

• Traditional debt collection agencies. A traditional debt collection agency’s primary function is to contact the individual in debt and attempt to recover the owed funds. They are not licensed legal entities, so they may not file a lawsuit or represent a business in court. However, they can provide valuable documentation and information should you choose to take legal action.
• Legal debt collection agencies. Sometimes referred to as a collections law firm, these agencies are run by licensed attorneys with experience in debt recovery. As such, they can file lawsuits, obtain and enforce judgments, and pursue other necessary legal remedies on a business’s behalf.
• Debt buyers. If a business no longer wants to pursue collection, it may choose to sell the debt to a debt buyer. As the name suggests, a debt buyer purchases the unpaid debt for a fraction of its face value. The debt buyer then becomes the legal owner of that debt and thus is responsible for all further collection efforts and outcomes.

What collection agencies are not allowed to do

Several laws are in place to regulate debt collection services. The Fair Debt Collection Practices Act (FDCPA) sets the rules concerning debt collection agencies, along with consumer protection from abusive debt collection activities.

Generally, the FDCPA prevents debt collectors from conducting abusive or harassing behaviors, including the following practices:

• Calling the borrower repeatedly at unusual times. A debt collector cannot communicate with the consumer at unusual times — typically before 8 a.m. or after 9 p.m. in the consumer’s time zone — unless agreed upon by a court or the consumer.
• Falsely threatening to sue the borrower. A collection agency cannot threaten to take legal action when it is not intended or cannot be taken.
• Threatening or harassing the consumer. The use or threat of violent physical harm on a consumer, their property, or their reputation is a violation of the FDCPA. Continuously calling or engaging in conversation with the intention of annoying, harassing, or abusing the consumer is also prohibited.
• Using unfair practices to collect any debt. Debt collectors cannot collect interest, fees, charges, or incidental expenses unless the amount is explicitly authorized by the original agreement. This also includes depositing (or threatening) to deposit a postdated check from the borrower that’s earlier than the date on the check without providing advance written notice.
• Providing false or misleading documentation on who is collecting the debt. The FDCPA forbids agencies from designing, compiling, and furnishing forms to create a false impression that the debt is being collected by another entity.
• Directly contacting a consumer who has legal representation. If a collection agency knows a consumer is being represented by an attorney regarding their debt, the agency cannot go above that attorney’s head to communicate directly with the consumer. Direct contact is only permitted if the attorney cannot be reached or gives express consent for the agency to do so.

If a collection agency you’re considering mentions any of the above as part of its process, it’s your job as a small business owner to look elsewhere for legally compliant debt collection help.

[Read more: Is Factoring Receivables Right for Your Business?]

Tips for finding the right debt collection agency 

Choosing the right collection agency can significantly improve your chances of recovering unpaid debts while also protecting your business’s reputation and preserving customer relationships. Before signing an agreement, take time to carefully evaluate potential partners using the following guidelines:

• Do your research. Look for agencies with a strong track record serving small businesses in your industry, and verify that they are properly licensed, bonded, and insured.
• Evaluate its reputation and professionalism. An agency’s collection practices reflect on your business, so look for a company known for ethical conduct, responsive customer service, and compliance with applicable laws.
• Compare costs. Understand whether the agency charges contingency fees, flat fees, or a combination of both, and make sure the pricing aligns with the value of your claim.
• Ask about skip tracing. Effective agencies use skip tracing tools and databases to locate difficult-to-find debtors.
• Consider technology and reporting capabilities. Many agencies offer online portals that let you track account status, communicate with collectors, and review performance reports, making it easier to monitor collection efforts and stay informed.

How to reduce overdue receivables before they go to collections 

Strong accounts receivable management can help businesses reduce late payments, maintain healthy cash flow, and avoid the need for third-party collections. By establishing clear payment expectations and addressing issues early, companies can improve payment performance while preserving valuable customer relationships.

Establish clear payment expectations

Define payment terms before work begins and include them in contracts and invoices. Clearly communicating due dates, accepted payment methods, and any late payment policies helps reduce misunderstandings and encourages customers to pay on time.

[Read more: What Are Net Payment Terms?]

Invoice promptly and make payment easy

Send invoices as soon as products or services are delivered rather than waiting until the end of a billing cycle. Offering convenient payment options — such as ACH transfers, credit cards, or online payment portals — removes friction and makes it easier for customers to settle balances quickly.

Automate reminders and tracking

Accounts receivable software can automatically generate invoices, send payment reminders, and flag overdue accounts. Automation keeps collections organized, reduces manual work, and ensures customers receive timely notices before invoices become significantly delinquent.

Follow up early and consistently

Don’t wait weeks to contact customers about missed payments. A courteous reminder shortly after the due date, followed by a structured follow-up schedule, can resolve many issues before they escalate and significantly improve the likelihood of collecting the balance.

Encourage early resolution

When appropriate, incentivize prompt payment through early payment discounts or work with customers experiencing temporary financial challenges by offering a written payment plan. Addressing issues proactively can improve recovery rates while maintaining positive business relationships and avoiding the need for third-party collections.

When in doubt, consult with a financial or legal professional who can help you evaluate your options and find one that best suits your needs.

Danielle Fallon-O’Leary contributed to this article.

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