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Contract financing is using a contract that promises future payment for services you will provide as a guarantee for a loan. It is especially useful if you need a cash injection but do not have collateral available to provide as a guarantee. Instead, you are using the future promise of payment from a client represented by the contract as that guarantee.
- Since the contract serves as collateral, the client's financial strength is more important to the lender. With that, your company’s credit record won’t have too much of an impact on this opportunity. The downside is that the financing costs will cut into your bottom line.
How Contract Financing Works
Contract financing starts with obtaining a signed contract for a large project. The lender will take a close look at the contract and customer to determine if they are interested in providing a cash advance.
- Payment details in contract matter: Many contracts outline the terms of partial payment along the way. A lender will carefully review the expected payment timeline.
- Client must have a good reputation: A lender will want to see that the client has a good credit rating and a clear schedule of payments in the contract.
- Company must have a good track record: The lender will want to see that your company has a track record of completing work on time.
- Up to a 90% advance: In general, contract financing will offer up to 90% of an invoiced amount upfront. The company can use these funds to cover working costs. After the invoice is paid at the end of the contract, the company will receive the remainder after the final invoice is paid.
Contract Financing Example
Here’s how a contract financing agreement would work in real life:
- Obtain the contract: A construction company that builds commercial office space obtains a contract with the federal government for a new building.
- Get the specifics in writing: The details of the contract in this example include 12 milestone tasks, deadlines, and payments. Each payment will be $150,000, it takes the client 30 days to pay the invoice.
- Speak to a contract financing company: The contract financing lender evaluates the financial strength of the client, which is good as the federal government. They also evaluate the track record of the company to produce results on time. Since everything looks in order, the lender offers an advance percentage of 90% for each milestone.
- Invoicing responsibilities move to the lender: You agree to the contract financing terms. At this point, the lender will take over the invoicing responsibilities for the project.
- Get to work: You receive $135,000 upfront to start working on the contract goals.
- Receive the remaining payout after invoices are paid: After the work is complete and invoices are paid, you’ll receive the remaining contract amount. Since you agreed to a 2% factor fee, you’ll receive another $12,000 after the invoice is paid. But the lender will keep $3,000 for their role in the process.
Pros and Cons of Contract Financing
As with all financing options, there are advantages and disadvantages to consider with contract financing.
Pros of Contract Financing
- Easier cash flow management: The upfront influx of cash offers an easier way to manage cash flow.
- No additional collateral: The contract itself serves as the necessary collateral.
- Creates more opportunities: A business can take on multiple projects at once.
Cons of Contract Financing
- Can get expensive: The risk of non-payment can lead to expensive financing charges.
- Must have a known client: Lenders want to finance contracts with clients that have a good track record and reputation.
5 Factors That Help You Qualify for Contract Financing
If you want to pursue contract financing, here are the factors that can impact your chances.
Contract financing lenders typically require a monthly billing amount. The amount of financing you receive will vary based on the size of the bills sent each month.
Time in Business
Although you don’t need to have decades of experience, most lenders want to know they are working with a reputable company. In most cases, lenders expect companies to be in business for at least six months to a year.
Customer Credit Rating
The entire deal hinges on the customer’s ability to pay for the contract. With that, lenders will look into the customer’s credit rating when making a decision.
The promise of a contract isn’t enough. Instead, lenders require a signed contract. It’s a better option if the contract has designated milestones outlined in the contract.
Lenders want to make sure that the borrower can actually complete the work outlined in the contract. As a business seeking contract financing, you’ll find better terms if you have a solid history of completing work on time.
Does My Company Really Need Contract Financing?
Contract financing might be a good idea for your business if:
- You don’t have the funds to complete the contract upfront.
- You know that you can complete the work with the right funding.
- A bad credit score makes another loan option too expensive.
- You prefer to leverage others money to complete projects and are okay with the cost
How to Get Contract Financing
If you want to pursue contract financing, here’s the game plan.
Step One: Create a Contract with Your Customer
Work with your customer to create a contract. The contract should include:
- Specific work milestones
- Specific payment terms
Step Two: Submit Qualifying Information to the Financing Company
Reach out to a contract financing company. They will have specifics asks but you could expect some of the following information:
- Years in business
- Work completion history
- Monthly billing amount
- Contract details
Step Three: Present Milestone Invoices to the Lender
After you’ve accepted the contract financing offer, you’ll present milestone invoices to the lender. As you complete the necessary work for these invoices, your lender will often collect the funds directly from the customer.
Step Four: Receive a Percentage of the Invoice Amount
Each time you embark on the next milestone of the project, you’ll receive a portion of the invoice amount upfront. You can use these funds to complete the necessary contract work.
Step Five: Receive the Remainder After Contract Completion
Although you’ll receive some funding upfront, you’ll have to wait until after the work is completed to get the final amount you are owed. And of course, the funds you receive at completion will be missing the fees paid to the contract financing lender.
Where to Get Contract Financing
Contract financing is a useful opportunity for many business owners. Typically, these loan types are available through private firms online or in person. Contract financing companies include Green Capital Funding and Billd.
Be prepared to provide extensive information about your contract if pursuing this option.
FAQs about Contract Financing
Here’s everything you want to know about contract financing.