This is a guest post by Richard Lewis, Financial Engineering Counselors, Ltd.
Factoring is probably the most prevalent financing means for start-up and small to mid-size contractors. Factoring is the process wherein a factor, either bank or non-bank, legally ‘buys’ the invoice to your pre-approved customer. The factor will traditionally advance between 70-90%, almost immediately, thus providing the client with immediate cash flow for business usage.
When your customer pays, they pay the factor directly. The factor reduces the amount outstanding on that particular invoice, deducts its fees, and remits the residual balance to the company. In factoring, one of the primary components is the “credit worthiness” of your customer, i.e., their payment history and overall credit health.
Example: The company invoices a school district for work completed, $10,000. The factor will advance; say $7,000, 70% in this example, usually within 48 hours. When the school district pays, they will pay the $10,000 directly to the factor. At that time the factor remits the balance, $3,000, LESS interest and fees, to the company.
The problem with bonded contracts
During the financing process the financier has loaned or purchased the invoice and the outstanding payment belongs to the financier. The problem with “bonded” contracts is that the bonding company has a lien, the “first” right to payment, in the event of a default. This risk is not one that most banks or non-bank financiers will usually take. When and if they do, funding becomes that much more expensive.
To help alleviate this problem some bonding companies will “subordinate” their interest to the amount outstanding on that contract (invoice) to the factor. In the above example it would be $7,000.
If there is a bonding clause in your contract, there are a few requests that can be made when you negotiate the final contract:
- Ask the customer to release the bonding requirement because of both the difficulty in small businesses obtaining bonding and then the inability to get financing when bonding is obtained. Ask!
- If the work is as a sub-contractor, many prime contractors will be bonded and as a sub you may qualify under their policy. Again, ask! It doesn’t hurt.
- Request that the bonding company subordinate their interest only to the amount outstanding to the financier. With a yes, there should be no or few problems to moving forward with financing. It never hurts to ask! Please note: many/most will not subordinate their interest.
If none of the above work, there may still be some alternatives:
- Finance only those contracts/jobs that are not bonded
- There are a few financiers that will fund ‘bonded’ accounts receivables. But they can be very expensive, sometimes up to around 5%/30 days.
Richard Lewis is a consultant with Financial Engineering Counselors, Ltd. FEC is a diverse financial advisory firm that assists government contractors in obtaining their working capital needs. You can contact him at 703-992-8988.
