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.
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.
The Fallen on Hard Times Construction Business
Factoring might also be the right decision for contractors who simply don’t have a lot of free cash or working capital, even if it’s only a one-time situation. Between the challenges of balancing multiple projects and dealing with a slow paying customer, cash flow can quickly dwindle. At the end of the day, keeping your business afloat should be your number one goal, so even if invoice factoring is not a financing option you consistently rely on, there may come a time that it makes sense. And if it does, give it real consideration as to not sink the ship.
The “Having Trouble” Getting Financing Elsewhere Construction Business
In addition, securing a contractor loan or line of credit can be difficult for many businesses in the construction industry because they’re often viewed as too risky by traditional financial institutions. Unfortunately, for contractors with limited, poor or no credit history, it can be nearly impossible. Contractor factoring involves less red tape and hurdles to jump through, enabling companies routinely passed over by traditional lenders to more easily gain access to funds when they need it. Despite these advantages, there are other elements to factoring that should be carefully considered.
The Drawbacks of Construction Factoring
Though contractor invoice factoring offers immediate benefits for contractors in a tight spot, it also has its share of drawbacks.
Potential Customer Service Pitfalls
One glaring drawback to factoring is that customers will know you are dealing with clash-flow issues. There’s no getting around it: factoring inherently inserts a third-party into your relationship with your client, and there’s no way to hide it. Not only can the optics of needing financial assistance undermine your credibility with customers, but you also won’t have control over how the factoring company collects payments. With this in mind, it’s vital to work with a factoring company you trust.
Contractor factoring only applies to completed work, so if you need upfront cash before a project begins without another invoice in the pipeline that will cover it, factoring isn’t an option. In addition, factoring companies do not accept future or past-due invoices, only current ones. And if a customer fails to pay an invoice within 90 days, you may have to buy it back and assume the debt, assuming the factoring agreement was a recourse loan. A good financing option if you need cash to start a project but do not have any invoices you’re waiting on is Contractor Project Based Financing or Material Purchase Funding with a company like Billd.
Yes, invoice factoring can free up cash flow, fast — but in reality you’re also losing out on a pretty large chunk of change when you consider the factoring fees. Factoring companies typically charge a rate of 1.5 – 5% of the total invoice amount every 30 days, either at a flat or variable rate. For contractors already dealing with tight budgets and cash flow problems, this potentially throws another wrench into the gears.
Managing Construction Cash Flow
Overall, the most important thing is to keep your business going, no matter what. If that means using factoring to keep your company afloat when you’re experiencing financial strain, then that’s the right thing to do. However, there are other contractor financing solutions that might be a better fit, with less drawbacks, so it’s important to consider all of your options based on your business goals.
At Billd, we provide a payment solution that enables commercial construction contractors to free up cash for material purchases while enjoying the flexibility of 120-day payment terms. You get financing for commercial materials upfront with the freedom to pay it back at your own pace. Learn more about how Billd can help eliminate your company’s cash-flow problems so you can win more bids and grow your business.