What is Contract Financing?
Companies often use the terms contract financing, contract factoring, and "contractors financing" when looking for a lender to assist with their contract and invoice based financing needs. So what exactly is contract financing? When a company is financing their contracts or invoices they will normally turn to either an invoice factoring or a procurement contract financing lender. A financing lender can fund either type of company…one that sells to consumers (B2C) or a company that sells to other businesses (B2B) as long as the contract is with either a business or the government. Types of contracts typically financed are state, federal, municipal and private contracts and can include: With strong bidders who have solid contract finance solutions, contract financing can transform uncertainty into cash flow . Many contractors are highly skilled in what they do but sometimes not so skilled at managing their cash flow needs and funding. A contractor wants to be increasing cash flow while expanding their contracting business, not waiting for payments to come in from months and months of service. Contract financing ensures that as large of an amount of the contract can be upfront, allowing the contractor to get rolling quickly and limit their need for short-term personal or business loans. Contract financing can profit contractors both financially and emotionally as it manages the financial side of contracting. A contractor is putting their best foot forward to showcase their expertise, but is also facing tough competition for their bid. Because contract financing takes the guesswork out of whether or not the contractor can afford to add additional contracts to the fold, they can confidently take on new and challenging contracts.
Types of Contract Financing Lenders
Contract financing lenders vary significantly in form, with the key categories being banks, non-bank financial institutions, and contract financing firms. These groups can be further broken down by types of industries they focus on, and the size of the loans they offer. Generic bank lenders are generally bigger than the other two lenders. They will only consider lending to your business if your company is big and fairly established. Some banks may even have limitations on the industry your business operates within. Their products are limited to traditional loans, lines of credit, and several others but they generally show little flexibility. Bank lenders are bureaucratic, and the size of their loan offers are generally limited to $100,000 or less. Bank lenders are also generally slow at reacting to offers thus are not useful when you need a quick solution. Invariably, banks refer non-bank lenders as the next option for small businesses to seek financing.
Non-bank financial institutions are familiar with the demands of small businesses thus they have adapted to understand the needs of these businesses. For example, instead of having rigid requirements, they have flexible options for loans. The loan amount varies and will depend on the type of asset that the business is trying to finance. Non-bank lenders are also experienced at closing deals quickly and efficiently so that the businesses do not lose opportunities.
Contract financing firms are the most flexible and cost effective of the lenders’. We will explain in-depth the workings of contract financing firms in the next post, but just as an overview, contract financing involves the factoring of existing and incoming government contracts. A contract financing firm will pay your suppliers directly from your contract accounts or invoices and help you win more government contracts by providing you with 100% of your upfront cost. This type of contract financing lender will allow your business to cover start-up costs whilst allowing your business to offer low bid prices that are easy to win.
How to Qualify for Contract Financing
Generally, contract financing lenders are looking for qualified government, corporate or prime contracts and invoices to finance against. The contract needs to have an adequate purchase order release schedule or a letter of intent or agreement with a customer to finance. Contracts with an average or greater than average size and term are often more acceptable to a lender. When financing with a contract as the underlying asset, lenders will often take a hard look at the contract terms for red flags that could make it easier for the debtor to terminate the contract if they are not satisfied with the work.
Contract financing firms will also carefully review a company’s creditworthiness. If the terms of the contract calls for extended payment terms or if the company has a history of late payments with its suppliers or vendors, they may be less likely to approve the application.
Lenders will want to see contracts that are active right away. Those that already have a full release schedule or in progress – meaning there are assets that are already been put into service are taking immediate demands on your cash flow to support them. This is a good thing from the lender’s perspective because revenue is generated and invoices can be collected almost immediately. Banks are especially cautious of companies that sign contracts that will require extensive upfront spending or many months of work for little to no immediate incoming cash, as well as contracts containing unreasonable termination clauses.
Pros and Cons of Working with Contract Financing Lenders
In addition to providing an injection of cash, working with contract financing lenders can produce other benefits for your business beyond a lump sum cash payment for existing contracts. With a reliable source for short term financing, you are less likely to have to reject profitable short term contracts for lack of working capital. This increases your competitive advantage by enabling you to bid on additional contracts that are made possible with the additional working capital offered by a contract financing lender.
Contract financing lenders also offer a wide range of flexible financing options. Many of these financing solutions are completely customized around your needs, as opposed to loans from private investors or banks that require you to pay back with high-interest rates regardless of your current cash position. With contract financing, you only have to repay the financing when your invoice is paid for short term loans, and your current cash offering from the lender may be offered contingent on your successful bidding on future contracts.
Risks and Downsides
As with any financial decision, contract financing lenders can present a great opportunity for businesses, or they can lead to trouble if not pursued with caution. As any business owner knows, loans aren’t free money, and contract financing lenders charge interest on the loans they extend. Interest rates may vary considerably depending on the lender (and the risk the lender is taking on) and the size of the loan. Interest rates can range anywhere from the Prime Rate + 1% to Prime + 10%, with rates generally lower for larger loans. In addition to interest, a contract financing lender may charge one-time fees for services such as loan initiation or document preparation. Fees may be a few points of the loan or be based on the amount of your lending request.
It is important to note that the loan facility that a contract financing lender provides is contingent on payment terms of your contract with the prime contractor . For example, if the prime contractor is required to release 30% of the total contract value as an advance payment to your company, a contract financing lender will usually only fund 80-90% of any invoice you submit to the prime contractor. That may result in your company operating on a partial loan or credit until the prime contractor issues the advance payment. Similarly, when a prime contractor pays you, a certain percentage of that payment may be released, held in reserve, or subject to a retention balance or holdback. The contract financing lender may only provide a loan based on the amount that was paid by the prime contractor—not the full amount of your invoice—so it is critical that you understand the payment terms of your contract with the prime contractor and how those terms affect your ability to finance the contract with a contract financing lender.
How To Select the Best Contract Financing Lender
When selecting a contract financing lender, businesses should look for a lender that has a strong reputation. Experienced lenders understand the business and its industry. They know how to evaluate contracts and which ones tend to default. They can assist in vetting new customers.
Contracts with certain clauses are riskier than others. A lender who does not know this may give its approval too easily or reject contracts that are perfectly good. Financiers with experience in the industry will have a better grasp on these considerations.
Best practice suggests that a lender should be required to approve contracts. It may be unlikely that a financier would deny a contract financing request, but it is critical that the lender understand the future cash flows and obligations associated with the financing. Some lenders require that contracts be approved prior to submission. Others provide an "Approval upon receipt" option. In each case, the financial transaction itself can only occur after the lender agrees to provide subcontract financing for those specific contracts.
Companies should look for contract financing lenders that have suitable terms. Terms can vary significantly from lender to lender. For example, the standard advance rate is 90% because invoice payment guarantees typically do not guarantee that a customer will pay as agreed. During contract proceedings, there may be disputes over payment amounts. When this happens, an invoice is not paid. In such cases, contractors must use their cash flow to cover the gap. However, some lenders will offer to advance 100% of the invoices. The downside is that they often impose monthly costs and charge administrative fees that can be 10 to 20 times higher than the industry average.
Third party lenders offer contract financing. But there are lenders such as presidential angel lenders that are owned and managed by entrepreneurs. Essentially, the right entrepreneurs can earn their livelihood by only selecting low-risk contracts. Since they fund their own contracts, they only need to return the principal and some profit when the contract completes successfully. Although lenders seek a profit, their interest does not necessarily align with that of the borrower’s.
Inside lenders provide contract financing using their own capital. Their interest is aligned with the company’s because they want to see the company succeed to maximize their own return on investment at the end of the contract. Inside lenders usually offer better terms than outside lenders. Often, they will offer more than 90% of each contract value.
Contract Financing vs. Other Types of Financing
Contract financing differs from other common financing methods in a number of ways. For starters, contract financing is better suited to small and mid-sized businesses that do not have the resources to wait for payments from larger parties to trickle down to them. Other popular financing methods are less ideal for these kinds of companies.
One limitation of traditional loans or lines of credit is that they apply an interest rate and require full repayment before any funds are released. For a company that is awaiting a large payment from a contract but needs working capital now, this isn’t a good solution .
Contract financing is a more flexible solution, as a company can decide how much cash they would like to receive for their contract and receive that amount at an interest rate that turns out to be lower than the prevailing market rate. In addition, a company will know whether they are getting any of these funds before they agree to anything, once they go through the underwriting process.
Since contract financing lenders will advance funding against both contracts and invoices, companies who are receiving delayed payments for contracts or projects have access to needed capital much more quickly.
Additionally, contract financing lenders tend to be more flexible than traditional lenders when it comes to the completion of one or more projects. Finally, contract financing lenders tend to charge an interest rate similar to a line of credit.