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Even when you have the expertise to fulfill a particular contract, the lack of funding can still take away your chance to win the contract. For most contracts, you’re either paid at the end of the contract or in milestones throughout the process. In both cases, you will need to put up some of your own money to perform some initial tasks as analyzing data and buying materials. When you are unable to put up the funds, then the customer might overlook your application for another contractor.
If you ever find yourself in such a situation, the only solution left is to seek contract financing. This is similar to a loan received from a bank, only now the customer’s creditworthiness is in question rather than yours. Before a lender can provide funding for the contract, they analyze the terms of the contract for details about payment milestones to judge the amount of financing that will be provided.
The actual contract financing starts once you are awarded a contract by your customer. Nevertheless, some parts of the process take place even before the contract is awarded. For example, a customer may insist on proof that you can really fund the costs of the project. This is common in high-value contracts where the customer needs assurance that the project will not be stalled midway and cause delays. In such a case, you can request a lender to issue give you a letter of intent to fund.
This letter basically tells a customer that should you be awarded the contract, the lender is prepared to provide the funding. Therefore, this acts as proof that you have the funding as the customer required. Before giving you this letter, the lender will need to see the documents from your business and details of your tender. Business documents may involve bank statements, financial statements, company profile and reference letters from your previous customers. These documents help the lender assess whether you have credibility and resources to handle a contract. The details of your tender will also be used to confirm that your company has a proper plan to accomplish the contract.
Assuming your company has now won the contract, it’s time to receive the actual funding and start the work. To determine how much funding to provide and how to structure the funds, the lender will analyze the contract in detail. In order to determine how much financing your company will need in total, this will depend on the details you presented in your tender. You had to have estimated the cost of the project in the project proposal, and this will be used to estimate the amount of funding you need. This amount will then be dispensed in different ways depending on your company profile into three possibilities:
In this kind of contract financing, the lender only gives your company money to purchase materials, pay for employees, deliver a service or transport goods to be used in the contract. This means that you don’t really get to control the money, but rather the lender directly pays the suppliers and employees involved in the project.
This is the kind of arrangement you will normally find given to a company without an excellent credit score or one that is a startup with little credit history or experience. The lenders, in this case, are trying to lower the amount of risk they take by not committing a lot of resources to the project.
Here is a situation you will often find yourself in if the terms of the contract dictate that you will be paid in milestones. Consider the example of a project involving the construction of a high-rise building where the entire cost is estimated at $10 million. The contract might specify 10 milestones to be paid out after a percentage of the entire square footage is completed. Consequently, $1 million will be provided after each milestone is completed.
To provide the funding for such a project, the lender may create a separate bank account just for the project. It is into this account that the lender will be releasing funds for you to use on the project per milestone, and it is also where the customer will be paying for the project. Once the project is complete and all monies paid, the lender will close the account.
You are much more likely to encounter this kind of structure from a small lender who would like to keep an eye on the project without risking the entire amount of funding. Whenever you’re financed in this kind of structure, it is crucial to have good communication with your lender so that you can always request for more funds when needed.
In this kind of contract financing, you’re furnished with the entire contract amount at once into your company’s bank account. This is provided either as a business loan or an overdraft, and you have total control of the money. The length of the loan will be equivalent to the length of the contract and is expected to be paid back by the time the contract is complete.
Lenders will only give a company this kind of contract financing when they and the have an excellent credit record. The client’s reputation will also be considered where often a government contract or reputable company will earn you this privilege.
With the structure of the financing determined, you will have to consider the fees charged by the lender. When it comes to fees, there are 4 terms you need to be aware of – advance amount, factor fee, advance percentage and advance term.
To understand these terms, it’s best to use an example that you might encounter in real life. In the example above with the building construction, the advance amount would be the entire $10 million required to complete construction. However, the contract is paid out in milestones of $1 million. Once a milestone is reached, you would inform the lender who would then send an invoice of $1 million to the customer. If, say, the advance percentage is 90%, it means that the amount required for the project would be $900,000 (90% * $1,000,000). The remaining $100,000 is paid out to your company for the work done.
The advance term is used to determine the factor fee. When the advance term is longer, the factor fee is higher. For example, if the client takes 30 days to pay for an invoice, the factor fee may be as low as 1.5%, but a longer advance term will attract a higher factor fee of, say, 2.5%. As such, if you’re lucky to have a good customer with a 30-day advance term, your factor fee would be 1.5% and the lender would deduct $1,500 (1.5% * $100,000) as a fee with the rest being paid out to you.
For a lender, there are several factors to consider before they can provide contract financing to a company. One of their considerations is the creditworthiness of the company providing the contract. The reputation of this company is even more important than your own company’s because they will be the ones paying the contract. Lenders will place a priority on reputable private companies and government contracts because they can be assured of payment.
Your company’s profile will also come into question to determine if you have the resources to complete the contract. The lender may deem your company unable to complete a project for lack of, say, qualified personnel needed for the project. How long you have been in business and your financial statements will also be considered when the lender needs to structure the funding.
The lender will also carefully study your proposal to determine if it is achievable at the price set. Their experts will determine this and decide if they can indeed back the contract considering their own profitability. All the same, lenders will have a minimum amount of financing below which they won’t even consider.
In general, banks don’t get involved in contract financing because this is not exactly a loan. Instead, funding is provided by private companies that deal with factoring. Most of these can be found online, and you need only send an application online and await a phone call. Once you are given contract financing, it is important to read the terms of the contract carefully to know exactly what you are getting yourself and your company into.
