Contract Financing: What is it, who does it help, and how does it work?
Posted June 17th, 2021
Contract financing is a way for businesses that operate through contracted work to secure funds in advance of the work being performed. If you’ve ever turned down work because you didn’t have the cash flow for the initial labor, materials, or other costs associated with the project, contract financing might be the financial solution for you.
What is contract financing?
Contract financing alleviates the cash flow gap that occurs when you have expenses related to a new project contract, but will not be paid by your customer until after the work is underway or completed. The financing is a loan collateralized by your contract. Contract financing differs from invoice factoring in that the advanced funds are available before you send an invoice. Also, you still own your receivable.
Funding limits vary, but typically a contract financing firm will lend up to 20% of the contract value. (That is Mobilization Funding’s funding cap on contract-backed loans, as well.)
Who does it help?
Contract financing works best for businesses that have a solid performance history and are growing faster than their free cash flow can accommodate. These businesses usually have their operational cash flow management under control, and may even have other forms of funding available such as SBA loans or credit lines from their bank. However, contract financing allows them to grow securely by accepting large contracts without straining their cash flow or drying up their other funding options, which are better utilized elsewhere.
For example, let’s assume Lightning Man Inc. is an electrical contractor in Tampa, Florida, owned by Joe Mitchell. The company has an annual revenue of about $2 million, and is in a phase of rapid growth. They’ve just been awarded a $1.8 million contract with a GC. The work includes all electrical systems in a new corporate campus park. The contract is Paid When Paid, with monthly billing at the end of every month. Joe knows he’ll have at least three payroll periods for his crew, not to mention supplies and materials expenses, before he’ll even submit his first pay app.
A contract-backed loan allows Joe to cover those expenses without dipping into the cash flow for his other projects or the operating cash he needs to pay for his overhead expenses. It also means he can save his bank line of credit for other organizational costs associated with Lightning Man’s growth.
Contract financing isn’t only for construction contractors. If you earn revenue through contract work, and you could use funds to cover the initial costs of that work, contract financing may be a viable funding solution for you.
How does contract financing work?
Let’s stay with our friend Joe aka “the Lightning Man” for a bit longer. Joe knows he needs payroll money before he sends an invoice, so invoice factoring can’t help him here. He calls Mobilization Funding — we’ll use ourselves as an example to keep things easy — and asks about contract financing.
After a quick preliminary chat, one of our team members tells Joe, “It sounds like you’re a perfect fit. You have a great work history, this work is right in your wheelhouse, and your business sounds solid. I’ll send you a follow-up email with our next steps.”
Here’s what a contract financing company typically asks for:
- A complete loan application
- Owner identification
- Copy of the contract for the project
- Company financial documents such as bank statements, tax returns, income statement, balance sheet, and an accounts receivable report
With the copy of the contract, Joe and our Project Funding Manager sit down to create a Cash Flow Schedule. (We have a sample Cash Flow Worksheet available on our site. Click here to access it.) This shows Joe when his project will have cash flow gaps that our loan can cover, and when the project will be self-funding. We align our repayment schedule to when Joe’s customer will be paying him, so that he doesn’t have to use his organizational cash flow to pay us back.
The loan documents are executed, and a bank account under the name and Tax ID of Lightning Man Inc. is opened for the funding. Since the loan is based on the contract, it is imperative to the lender that all funds for this job stay on the job. Through the execution of a funds directive, all monies associated with the project come through this bank account.
In the end, we loan Joe $200,000 for labor and sub-labor on the project. He pays us back in installments as he receives payment from the general contractor. Joe is able to start the job with the right amount of labor and all the materials he needs, which actually ends up saving him money through his team’s efficiency. He completes the project and earns a healthy margin. Best of all, the GC appreciated Joe’s ability to expedite his work and stay ahead of schedule. Lightning Man Inc. has a new and important ally in its quest for growth.
When your business has the cash to start new work without sacrificing other projects, or cash that can be used for other business expenses, your team can get to work with total confidence and YOU can focus on your real job — growing your business.
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