When a business has the expertise and resources to undertake a contract but lacks the funds to complete it, the lack of funding may cost it the contract. The term contract financing refers to how a business can receive advance funding on an awarded contract it is yet to complete.
Most commercial contracts in the construction industry are paid for in milestones throughout the process or fully at the end of contract completion. In either case, business owners will need to invest their own money to prepare and execute the specific project.
For instance, the business will need to source funds for initial tasks such as data analysis and sourcing materials and tools. If a company cannot raise the funds it needs to execute or complete a contract, the client may even cancel the entire contract and choose to go with a competitor.
What Is Contractor Financing?
Contract financing is an excellent way for a business to access business loans against a contract which it has already won. In such a case, the lender will consider the creditworthiness of the client and not the business’s when considering the funding request.
Before funding the contract, the lender may analyze the terms of the contract and especially payment milestones and timelines as well as the contract price. Contract financing differs from traditional bank loans in many ways. It is underwritten based on the terms of a contract the business has already signed and the creditworthiness of the client rather than the borrower’s assets or credit record.
How Contract Financing Works
Contract financing is available to a business that has already won a client contract and is ready to fulfill it once funds are available. In some cases, the process of seeking contract financing may begin long before the contract is awarded.
A good example of such a situation is when the client demands proof of funds to meet the project’s costs before the business is awarded the contract.
Clients seeking high-value or time-sensitive services may insist that the business provides proof of funding before awarding the contract. This demand is often required to assure the lender that the project will be completed and not delayed or stalled due to a lack of funds.
In such a case, the business may request the lender to issue a ‘letter of intent to fund’ to enable the business to win the contract. As the name implies, this letter lets the client know that the contract financing lender is prepared to advance funds to the business should it win the contract.
Before the lender issues the letter of intent to fund the project, they may demand business documents and details of the contract. Lenders often require such documents as the business’s profile, financial statements, and reference letters from previous clients. These documents help the lender assess the business’s credibility, resources, and capacity to fulfill the client contract.
How to Qualify for Contract Financing
Contract financing is different from a traditional business loan in many ways. For starters, it is an unsecured loan, hence riskier than the conventional secured loan. Because of this, the lender may take extra precautions and look at more factors than they traditionally would before approving a business loan. Here are the three most notable factors that a lender will consider when evaluating a business for a contract loan.
The amount of money a lender can advance a business will largely depend on the borrower’s average monthly billing. This does not refer to the average amount the business pays in bills per month; rather, it refers to how much the company receives from its customers in a month.
The lender will want to know that the business’s monthly income is sufficient to cover the loan amount should the project client fail to pay.
While the client’s contract is the collateral in this loan, the lender will want to know that the business can cover the amount in a reasonable time even without the contract milestones or completion payments.
Time in Business
The duration in which the business has been in operation is one of the most critical factors for contract financing. New businesses are riskier than businesses with deep roots in their market; hence lenders will be reluctant to loan them.
Most contract financing lenders will only consider businesses that have been in operation for at least six months to a year. However, the minimum operation period may vary depending on the lender and their lending cap and the borrower’s industry.
Credit Rating of the Customer
A lender will scrutinize the creditworthiness of the contract client before approving a loan because it is the client that pays the loan. The lender will look at the client’s credit history, business rating, and other factors before deciding whether to approve the funding.
Often, the financier may advance the business as much as 90% of the contract invoice amount, especially in a government contract financing. It will want to know that the customer is good for the money and will make invoice payments as per the contract details without fail.
Types of Contract Financing
Contract financing can be categorized based on how the project funds are monitored and controlled. Most lenders will put measures in place to track and even control the contract payments and expenses. The more established the borrower, the less the lender will feel the need to manage the finances.
Here are the three types of contract financing options available to a business:
1. Lender-Controlled Contract Financing
In this form of contract financing, the lender deposits the borrowed funds into an account separate from the borrower’s main account as per the contract terms. The lender will monitor the movement of money in and out of the account throughout the load duration. When the contract is completed and all payments made, the lender will deduct charges from the account, transfer the funds to the borrower’s account, then close the loan account.
2. Borrower-Controlled Contract Financing
In this form of contract financing, the borrower is in full control of the contract as well as its finances. The funds may be deposited into the contract account as a short-term loan or an overdraft. While the loan may be used at the borrower’s discretion, the lender will often monitor account transactions to ensure the funds are responsibly managed and used for the contract only. The lender may charge interest every month from the loan account and the entire amount at the fulfillment of the contract.
3. Purchase Order Contract Financing
This contract loan caters to purchasing raw materials, inputs, labor, packaging, service or product delivery, or other costs of fulfilling the contract. With this contract financing type, the lender may make direct payments to suppliers and service providers rather than advance cash to the business. Because of its low risk, this is a popular form of financing for new businesses or companies with a less-than-excellent credit score.
Where to Get Contract Financing
Because contract financing is technically not a loan, banks generally do not get involved in it. Instead, private firms that deal with factoring are often the go-to lenders for this type of funding. Most of these firms operate or can be found online and often offer different packages of the same type of funding.
A business seeking contract finding may need to choose from contract financing, accounts receivable factoring, and invoice factoring. These firms are not as tightly controlled as banks; hence, borrowers must take the time to understand the finer details of contract financing offers before committing their businesses to a funding offer.
FAQs About Contractor Financing
Contract finance is a form of funding that allows a business to receive short-term loans or capital finance to undertake a tendered contract.
Yes. While the contract is the collateral for the loan, lenders will often demand proof of capacity to cover the loan should the contract fall through.
This is an authorized disbursement of funds to a business before the contract is completed.
There are various ways your business can finance a government contract, including invoice financing, purchase order financing, supplier financing, accounts receivable refactoring, or asset-based lending.
It is not unusual for the government to pay a certain percentage of a project cost up-front. However, most government contracts detail the terms of payments to help businesses secure funding from other sources. Typically, the final payment is paid upon successful completion of the contract.