Is your commercial construction business waiting too long to get paid? Slow-paying customers have long been the norm in the construction industry, particularly in commercial construction. Barely one-fourth (26%) of construction firms get paid within the time frame stated in their contract, according to a 2020 survey of construction businesses, while 80% spend much of their work hours following up on late payments.
Long waits for payment leave your commercial contracting business short on the working capital necessary to buy materials, pay subcontractors and move forward on projects. Time spent tracking down payments is time that could be better spent marketing your business, quoting estimates and landing new customers.
Commercial contractors seeking a solution to this financial quandary often turn to material financing or invoice factoring to access the cash they need. But what’s the difference between these two types of financing, and which one will work best for your business?
What Is Material Financing?
As the name implies, material financing is a way of financing the building materials necessary to complete construction projects. When you need materials from a supplier, you work with a material financing company that pays the supplier upfront for your purchase. The supplier gets paid immediately, you get your materials immediately, and everyone’s happy. You repay the financing company over time, with interest, so they’re happy, too. Most material financing companies offer payment terms that align with payment cycles, either pay when paid, or up to 120 days.
What is Factoring?
Instead of waiting for customers to pay, you can quickly get cash from outstanding invoices by factoring. In this process, a financing company called a factor purchases your unpaid invoices, and pays you a percentage of the value (usually between 70% and 95%, which is called the advance rate). The factoring company then takes over collecting payment from the customer. After the payment is received, the factor pays you the remaining percentage, minus their fee—usually between 1% and 5% of the invoice amount.
Material Financing vs. Factoring
As you can see, there are some major differences between factoring and material financing. Here’s a closer look at how these financing methods differ.
Advantages and Disadvantages of Material Financing for Contractors
With material financing, you don’t have to drain your cash reserves or max out business lines of credit to pay for building materials upfront. Instead, you can use your working capital for other critical needs, such as making payroll, marketing to new customers, and keeping existing projects on schedule.
Even if you normally rely on supplier terms to purchase materials, most suppliers offer 30 to 45-day terms at most. If your construction business is like many, that could still leave you waiting 60 days or more before the customer pays you. Material financing companies, on the other hand, offer longer terms that are more in line with when you can actually expect customers to pay.
Suppliers love it when commercial construction companies use material financing because they get paid upfront. In fact, this can qualify you for cash discounts, which leaves even more of your company’s hard-earned cash in your bank account. The cash discounts might balance out or even exceed the fees and interest charged by the material financing company.
Unlike factoring, with material financing you don’t have to hand off your invoices to an outside company to collect. You don’t have to worry about a third party contacting your customers for payment. You’re still in control of your receivables and your business’s image.
With material financing, financing happens before the project begins. This means you can bid on, and successfully start, larger projects that you may not have been able to financially accept. With factoring, the financing occurs after the work is completed, meaning you still had to find a way to pay for materials to get started.
Advantages and Disadvantages of Factoring for Contractors
If you have unpaid invoices you’re struggling to get paid for, factoring can take the hassles of follow-up off your hands. Instead of spending hours making collection calls, your team can focus on more valuable work. Meanwhile, you get paid for most of the outstanding invoice amount immediately, which allows you to pay your crew and any other expenses that have come up during the course of the work.
Invoice factoring can also be a lifesaver if your construction company is having financial difficulties or cannot qualify for other types of financing.
However, it’s important to know the negative aspects of factoring. For one, there are two types of invoice factoring agreements: recourse and non-recourse. Most invoice factoring agreements are recourse, meaning if the customer doesn’t pay within a certain time, you must purchase the invoice back from the factoring company. Clearly, this could cause even bigger cash flow issues than you started with.
In addition, factoring companies generally limit the kinds of invoices you can factor. Typically, the invoice must be open, must be for work already completed, and cannot be overdue. In other words, you’ll need to wait until the work is done (and you’ve already spent money on materials at a minimum) to factor the invoice. On the other hand, if you wait too long and the invoice becomes overdue, you can’t factor it.
The final downside of factoring: A third party—the factoring company—will start contacting your customers asking for payment. At best, this just signals to your customer that you need help paying your crew; at worst, customers may fear you’re having financial difficulty and won’t be able to complete their project. This could harm your construction company’s reputation and its ability to get new work.
