Contract Financing: How You Can Use It to Finance Your Business

What is contract financing?

As anyone in a business such as construction knows, getting a big contract can be a big step forward for your business.

Then you realize you need to pay for it. 

If you’ve ever found yourself in that or a similar situation, where you’ve got a big job to pay for but you won’t get paid until you reach the first milestone, or worse once the entire job is completed, then contract financing was designed for you.

Contract financing uses open contracts you have as collateral to approve you for funding. Those contracts also then determine the amount of funding you’re approved for. 

It’s similar to invoice factoring in that the advance is based on your customer’s creditworthiness, not yours. 

That’s because your lender is going to have to collect the amount from your customer, so they want to make sure they can be counted on to pay the contract. 

How contract financing works

We’ve covered the 30,000-foot view, but how exactly does contract financing work?

First, if you snag that big job and the customer wants confirmation that you can fund it (to ensure there are no delays), but you don’t have the cash, you can go straight to a lender and receive a letter of intent to fund which you can show them. 

Once you’ve signed up and been approved for contract financing with a lender, you receive a lump sum based on the size of the contract, often somewhere around 90% of the invoice itself, with the remaining 10% (minus fees) being released once the invoice is paid. 

Often, with such large jobs being split into milestones, these payouts happen for each milestone invoice.

For example, let’s say you sign a contract for a $200,000 construction deal with 4 milestones, each $50,000. 

Each $50,000 invoice would be sent to the financing company. First, they’d pay out 90% of that invoice, $45,000, immediately. Then, assuming the invoice is Net 30, once the finance company receives the invoice amount 30 days later, they send you the remaining 10% minus fees. 

This would then go on for each of the other 3 invoices until the job is complete. 

Now, let’s talk a bit about how fees work with contract financing.

Contract financing fees and rates

Factor fees, the fee typically associated with contract financing, typically range between 1.5 – 2.5%.

Using our example, if each invoice is $50,000 and your factor fee is 2%, you’d pay $1,000 in fees. So, for the total $200,000 job you’d pay $4,000 in factor fees.

Also, keep in mind that an additional fee might be charged in the event that your client doesn’t pay on time.

What businesses use contract financing?

If contract financing sounds like a useful funding method, but you’re not sure if it’s a fit for your business, use these points to help you decide.

Contract financing is a good fit for your business if:

• You have poor credit and likely wouldn’t be approved for a traditional bank loan
• Your customer does have good credit
• You have a signed open contract with a clear schedule of milestones mapped out
• Your business has a good financial track record and history showing you can get the job done in the allotted time. 

What kind of businesses does this make contract financing a good fit for? In particular, real estate development and other construction businesses are a good fit. Also, security, hardware/servers, and other various installation-oriented businesses are a good fit as well. 

How is contract financing different than invoice factoring?

If you’ve heard about invoice financing (also known as invoice factoring) before you might be wondering what the difference is between the two.

They have their similarities. However, where they differ primarily is this: 

• Invoice factoring: Uses open invoices / your accounts receivable.
• Contract financing: Uses open contracts for work that has not yet been completed. 

In general, a financing company that offers contract funding is far harder to find than invoice factoring. 

That’s because if the business does not fulfill its contract, the lender is not going to get paid, making this a risky investment for the financing company.

What do lenders look for when qualifying you for contract financing?

If contract financing sounds like it might be a good fit for you, you might be thinking about what the qualification requirements are.

Typically, lenders look at these elements to determine whether to approve your business for financing a contract: 

• Your customer’s credit: They’re the ones paying the invoice, so they need to know that your customer is reliable. 
• Your company: Do you have the resources necessary to complete the project and within the estimated block of time? The financing company will have their experts review your business’s profile to make sure. 
• How long you’ve been in business
• Financial documents: The financing company might consider your customer’s credit a primary qualifying factor, but that doesn’t mean they won’t also look at your financial health.

Keep in mind that these are all basic factors. Your financing company may consider other factors in their qualification methods. 

The best thing you can do to prepare is to review your own financial documents and make sure you’ve cleaned things up as much as possible.

Double-check the contract and make sure you estimated the time to completion correctly and that you have everything you need to complete the job.

Where do you get contract financing?

As contract financing isn’t technically a loan, it isn’t offered by banks. 

Instead, alternative lenders may offer contract financing (though not all do, for the reason we talked about earlier).

Before you apply for contract financing, make sure that it’s the right fit for you. 

Many alternative lending options now exist for businesses of all sizes and needs, from short-term lump sums of cash to business lines of credit you can tap into any time you need capital to pay for a contract.