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. Contract financing refers to how a business can receive advance funding on an awarded contract it has 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 Contract Financing?
Contract financing is an excellent way for a business to access business loans against a contract it has already won. In such a case, the lender will consider the client’s creditworthiness rather than the business’s when considering the funding request.
Before funding the contract, the lender may analyze the terms of the contract, 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.
What Types of Businesses Can Benefit from Contract Financing?
Several industries can benefit from contract financing. The defense industry, construction firms, childcare providers, and landscaping companies are some of the small businesses that can capitalize on this type of financing. These businesses can win contracts and then reach out to finance companies to get the money that they need.
Businesses with low credit that serve customers with high credit scores can also thrive with this type of financing. Financial institutions prioritize the customer’s financials and credit instead of yours when assessing your application.
Types of Contract Financing
Contract financing can be categorized based on how the project funds are monitored and controlled. Most lenders will implement measures 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 monitors the movement of money in and out of the account throughout the load duration. When the contract is completed and all payments are made, the lender deducts charges from the account, transfers the funds to the borrower’s account, and then closes 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 covers the purchase of 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.
The Benefits and Drawbacks of Contract Financing
It’s good to know the pros and cons before approaching a financial institution about contract financing. The pros and cons are highlighted below.
Benefits of Contract Financing
Contract financing companies give you access to the capital you need to win contracts and fulfill services. This type of financing can help you grow your LLC and generate more demand for your company.
You can end up with better payment terms, including lower payments stretched over a longer period of time. It’s even possible to get a better price from your customer since you have the capital ready to go. Any uncertainty in this area can prompt the customer to ask for a higher price.
Contract financing can also improve your company’s financial health and make it easier to scale. Borrowing money from a financing company gives you extra capital that you can use to serve additional customers.
Potential Drawbacks of Contract Financing
Contract financing companies may charge higher interest rates since this market is relatively underserved. Opting for a business line of credit or an SBA business loan can help you save money. While a good advantage of contract financing includes quick financing, it’s also possible to get funds quickly from various online lenders who offer traditional business loans.
Furthermore, some contract financing terms do not allow you to immediately access the capital. You have to fulfill certain benchmarks to receive additional funds, which increases your risk. People with good credit scores and impressive financial performance may find a better way to raise money.
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.
Monthly Billing
The amount of money a lender can advance a business depends largely on the borrower’s average monthly billing. This does not refer to the average amount the business pays in bills per month; instead, it refers to the amount 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, so lenders will be reluctant to give them money.
Most contract financing lenders will only consider businesses that have been in operation for at least six months to a year. However, the minimum operating period may vary depending on the lender, their lending cap, and the borrower’s industry. If you do not have as much experience, you may end up with a higher interest rate and fees.
Credit Rating of the Customer
A lender scrutinizes the creditworthiness of the contract client before approving a loan because the client pays the loan. The lender looks 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 by 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.
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 usually offer different packages of the same kind 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.
Contract Financing vs. Other Financing Options
Contract financing isn’t the only way to raise capital for your business. Here are some other choices you can consider.
Contract Financing vs. Bank Loans
Traditional financial institutions offer bank loans with fixed monthly payments. Bank loans are often more difficult to get and may require loan guarantees. Lenders will assess your application based on your cash flow, the age of your business, your work experience, and other factors.
Contract financing works better for businesses needing working capital and operating under tight budgets. The payments start off low and give you enough time to get started. Some contract financing companies offer limited access to money in the beginning in case a property owner backs out of a construction deal.
Contract Financing vs. Revenue-Based Financing
You will start off with lower payments if you use contract financing. It’s also possible to have lower monthly payments with revenue-based financing since repayment is based on a percentage of monthly gross revenue.
Lower monthly payments can give you the flexibility to hire subcontractors who can work on the projects. Your costs will go up for a revenue-based loan as your monthly gross revenue increases.
Contract financing lenders focus on the contract’s value and the client’s financial health. Revenue-based financing companies consider your monthly gross revenue and finances before giving out loans. If you have a reliable client and bad credit, contract financing may be the better choice. However, revenue-based financing offers flexible monthly payments and can compensate for having a client with bad credit.
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Contract Financing vs. Asset-Based Financing
Asset-based financing requires collateral. If you do not repay the loan, the lender can seize assets included in the collateral. Contract financing doesn’t have collateral, but you must demonstrate that the deal is complete or on the verge of completion, depending on access to additional capital.
It only takes a few days to get capital from either type of financing. Asset-based lenders review your assets and don’t spend as much time looking at financial statements. You can even get funding from an asset-based lender if your cash flow isn’t consistent.
Conclusion: Is Contract Financing Right for Your Business
Contract financing can help small business owners who need extra capital to close a deal or start working on a project. These lenders can help you get started, but they have a few perks over other choices. You don’t need a good credit score to get contract financing. The lender will focus on your client’s ability to pay for the project and the value of the contract.
However, you may end up paying more money for contract financing compared to other types of loans. It’s also possible to get locked out of some of the loan’s proceeds. Some lenders require that you fulfill benchmarks before unlocking additional capital within the loan. Meanwhile, traditional business loans offer immediate access to the money that you have borrowed.
Assessing the pros and cons, along with various alternatives, can help you make a good decision for your small business.
FAQs About Contract 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.
