Construction Factoring for Contractors: Everything You Need to Know
Unpredictable payment cycles and late-paying customers, combined with critical upfront project costs, can often put general contractors and subcontractors in a financial bind and unable to pay their bills, much less scale their businesses. In fact, half of all contractors say they don’t get paid on time.
For those struggling with cash-flow issues, contractor financing can not only help keep your business afloat, but also thriving. It frees up funds for the labor, materials, equipment and even overhead that you need to accept more projects and grow your business. One such option is contractor factoring, also simply known as “invoice factoring,” which can put cash in your hand when you need it (which is usually now), without having to wait on pending accounts receivables to come through. However, there are some potential drawbacks with construction factoring, so it’s vital to take a careful look at the pros and cons before deciding if it’s the right choice for your business.
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What is Invoice Factoring?
Contractor invoice factoring is essentially working with an outside financial entity that provides a cash advance on an unpaid invoice, minus a fee. Contractors may choose “spot factoring” for one-off invoices, or “contract factoring” for the lifecycle of a project. Here’s how it works:
- A contractor, who has submitted their pay app and is awaiting payment, sells that invoice to a factoring company, which immediately pays the contractor 70 to 95 percent of the invoice value (called the Advance Rate).
- From there, the factoring company interacts directly with the customer (likely the general contractor) to receive payment on the invoice.
- Once the customer remits payment, the factoring company sends the remaining balance of the invoice to the contractor — minus service fees (which is typically called the Factoring Rate).
Ultimately, the construction factoring company waits to get paid, while the contractor gets upfront access to cash in order to pay staff, secure materials and equipment, and even bid on more jobs.
The Main Components of Construction Factoring for Contractors
It’s important to understand the components of contractor invoice factoring.
The Invoice: Must be for an open invoice that is:
- Not overdue
- The work was already performed
- Not a future invoice
The Advance Rate – This is the amount that you, the contractor, will receive from the factoring company upfront. This is usually 70-95% of the invoice, and will be calculated from the Net Invoice (which subtracts any retainage).
The Factoring Rate – This is the cost to you for using contractor invoice factoring. It ranges from 1-5% per month of the open invoice.
Recourse vs Non-recourse – Most invoice factoring agreements between a contractor and financial company are recourse. Recourse invoice factoring means that if the customer does not pay within x days (usually 90), the contractor must buy the invoice back and assume the debt. Non-recourse factoring means the invoice remains with the factoring company, where they assume all the risk. There will be a higher factoring rate with non-recourse factoring.
Businesses That Should Consider Invoice Factoring for Contractors
The Startup Construction Business
When you’re just getting started as a contractor, cash-flow bottlenecks can stall your momentum. That’s why financing options like factoring are beneficial for early-stage construction businesses, which simply can’t afford to wait 90 days on payments while trying to take on more jobs and attract skilled workers. There’s absolutely no shame in using invoice factoring at a young construction business trying to grow and establish themselves in the industry. The increased cash flow from invoice factoring that can propel you to take on more projects may be well worth the downsides associated with it.