Why would a subcontractor need a construction loan? Managing cash flow and staying above water can be difficult for any business, but the problem is especially prominent in the construction industry. Due to a complex and inefficient payment system, contractors have a nearly impossible task of covering the cost of a job, especially before the pre-construction phase begins and for the first three months after you mobilize and begin working on a particular site.
That system forces you to have upwards of 20% or more of the total project cost up front to cover things like bond and insurance premiums, materials, payroll, equipment and supplies. You won’t be paid for 60 or 90 days after a project begins—and that’s if everything goes just right.
Construction Loan Alternatives
For a smaller job, you may be able to scrape together funding from a bank on a personal line of credit or secure a loan, but that loan is based on your personal assets. It’s risky and there’s only so far that a business owner can go with that strategy.
Banks continue to be reluctant to offer small business loans to contractors after the economic collapse of the late 2000s. Yet, according to the Federal Reserve Bank of New York’s annual small business credit survey, 61% of employer small business’ faced financial challenges in 2016. The number one problem was securing the funds they needed to expand.
Another 17% of respondents said they couldn’t get the money to pay for inventory or buy what they needed to fulfill contracts.
Without taking on a partner and giving up some of the ownership of their company, there are few good options for smaller and mid-sized subcontractors who are interested in bidding on larger projects and elevating themselves to the next tier.
It’s common for contractors to limp along with the cash they have on hand and then bill the general contractor for the work completed in the first 30- or 60-day time period of the project.
Then, with cash reserves largely dried up, you start to feel the pressure. You may start to cut employee hours or hold off on ordering supplies. To stay afloat, you may turn to a factoring company.
Factoring companies purchase submitted and approved invoices and pay you, the subcontractor ,a percentage of the funds owed (typically about 80%). The general contractor then pays the factoring company the full invoice amount, which recoups their initial payment to the contractor as well as a fee for their service. Any remaining profit is then sent to you.
Benefits and Drawbacks of Factoring
Used correctly, factoring can be a useful tool for a subcontractor. But there are disadvantages, too. It’s a headache for general contractors, who find themselves inundated with paperwork. It’s stressful for the subcontractor too, as it may be viewed by the general contractor as a sign that you’re having financial troubles.
Merchant Cash Advance Loans
What if you find yourself in such financial distress that you need payroll or equipment capital before you send the first invoice to your general contractor? This situation often results in a daily debit loan, which is when a company grants you a lump sum dependent on cash deposits in your company’s bank account and then the lender automatically deducts money from the company’s checking account on a daily or weekly basis until the loan is repaid in full.
The Slippery Slope of Cash Advance Loans
While daily debit loans and other cash advance loans have some benefits—they solve the immediate funds issue, have automatic repayment and can help boost business credit scores—they’re also difficult to sustain.
Cash advance loans are expensive and cannot be paid off early. And once the repayment schedule starts, the lender automatically deducts hundreds or even thousands of dollars from your account, making it more difficult to determine how much cash you really have on hand. You may be left feeling like you’ve solved one problem only to find you’ve caused a new one.
The Problem with Lump Sum Payments
Many contractors act under the mindset that if they could just get that extra $100,000 they need, everything else would work out. But that is often not the case.
A Cycle of Debt
Think about it from a personal finance perspective. If you as a business owner see that one of your employees immediately directs their paycheck to a payday lender, you can guess that employee is in a challenging financial situation. You hope it’s short term, but if you see the same behavior week after week, month after month, you know your employee is losing hundreds of dollars to fees and interest and is stuck in a spiral they can’t easily escape from.
By continuously turning to a factoring or daily debit company, your business is in the same boat as that employee. And like him, the situation is stunting your financial growth by spending money on interest rather than setting it aside for your next big project.
Properly allocating the lump sum once it comes in is often the worst part for subcontractors. If the money is spent working backward and paying for work that was already done, you’ll find yourself short again and likely need another loan to make it through to the next pay out. And the next. And the next. Each loan means more profit flying out of your pocket and into the lender’s.
And if the unexpected happens, like a weather delay or a change order, there is even potential for you to lose money on a particular project. Those cases put tremendous stress on the entire business model and put your future projects at risk.
Cash in on Opportunity
In a perfect world, a subcontractor would grow slowly, setting aside money for each new job you pick up in order to fuel any upcoming projects. You’d have a great track record with estimating project costs low enough to keep you competitive, but have the bid high enough that you can turn a healthy profit and manage any setbacks that will arise.
The good news: Now is a great time for contractor growth.
The U.S. economy is booming and the construction industry is seeing explosive growth. Dozens of airports around the country are under major construction, or are ramping up to start their renovations. Developers and Fortune 500 companies need contractors now more than ever to build their massive technology centers, enormous housing developments and sprawling office parks. Opportunity is everywhere.
Now is the perfect time to grow your business, whether that growth is $100,000 to $500,000 or $3 million to $10 million. The trick is in doing your research to make sure you are financially prepared to make that leap.
A Cash Flow Partner
One of the best ways to move your business forward is to partner with a company that is committed to your mission and is knowledgeable about your industry. You need a company that is able to offer you the funds you need when you need them and sets a repayment plan in line with the cash flow cycles of your business. Having such a partnership allows you to focus on doing the high-quality work you were hired to do and minimize the stress of cash flow management along the way.
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