Construction factoring is a specialized type of invoice factoring adapted to work in the construction industry. It helps subcontractors improve their cash flow by financing their net 30/60 invoices from commercial clients and General Contractors (GC).
This article explains how construction factoring helps you, how it works, its advantages, and its limitations. The article will help you determine if it’s the right solution for your company. We cover the following:
- Do you offer net-30 terms?
- How does construction factoring work?
- How is it different from invoice factoring?
- Advantages
- Limitations
- Qualification criteria
1. Do you offer net-30 terms?
Construction subcontractors typically have to offer net-30 (or longer) terms to their business clients. Their clients require this as a condition for doing business with them. However, offering payment terms is often a challenge for subcontractors, putting them in a difficult position.
Subcontractors need funds to pay their employees, materials, equipment rentals, and other expenses. They can’t wait for weeks to get paid. This situation can lead to cash flow problems, especially if your company does not have a cash reserve.
a) Two possible solutions
There are two ways to handle this problem. The simplest option is to offer your clients a discount for paying quickly. Offering clients a 2% discount if they pay within ten days is typical. However, this can be negotiated.
This strategy has one limitation. Your clients retain the option to pay on their usual terms. Consequently, you can’t always rely on early payments.
The most reliable solution is to use financing. It allows you to handle the financial gap between invoicing and payment effectively. One of the most effective solutions for this challenging problem is construction factoring. It is designed specifically for subcontractors who want to improve their cash flow.
2. How does construction factoring work?
Construction factoring is a specialized type of invoice factoring that has been adapted to work with the construction industry. Subcontractors can use the program to get financing for invoices tied to completed commercial work or work segments.
Invoices are financed in two installments. The first installment provides most of the funds, with a portion held in reserve. The second installment settles the transaction.
a) First installment
The first installment is called the advance. On average, it covers 70% – 80% of the invoice. The advance varies based on the invoice details and is deposited once the factor processes the invoice.
b) Second installment
The second installment covers the remaining 20% – 30%, less the factoring fee. It is deposited once your customer pays the invoice in full. This installment settles the transaction for the invoice.
c) Retainage invoices
Construction invoices are typically subject to a 10% retainage (varies). This part of the invoice is retained until later and used to handle disputes and other issues.
Unfortunately, retainage invoices cannot be factored. Note that invoices with a retainage component will be financed net of retainage.
3. How is it different than conventional factoring?
Construction factoring is similar to invoice factoring. However, it differs from invoice factoring in five key areas.
a) Progress billing
Conventional factoring companies typically don’t work with clients that use progress billing. This is because progress billing invoices are difficult to process and carry a higher risk.
Construction factoring companies have adapted their workflow to handle progress invoices. This allows them to work with subcontractors.
b) Invoice verification
Factoring companies typically verify invoices before funding them. The process is simple and usually done through the customer’s vendor portal. Unfortunately, this process does not work well for construction invoices.
Construction factoring companies have adapted their verification processes to handle progress invoices, invoices with retention, etc. Consequently, the process can be more ‘hands on’.
c) Minimums
Operating a construction factoring program is labor-intensive for the finance company. Consequently, construction factoring companies can work only with subcontractors that invoice above a specified minimum. Minimums vary by company but are about $50,000 per month.
d) Pricing
Construction factoring prices are typically higher than conventional factoring lines of the same size. This is done to account for the risk profile and process management. Learn more about factoring rates.
e) Advances
Most construction factoring programs typically advance 70% to 80% of the invoice as the first installment. This is somewhat lower than conventional factoring advances. The lower advance helps manage potential underpayments and other invoicing issues. Ultimately, the advance is adjusted to match the risk profile of the transaction.
4. Advantages
Factoring plans have several advantages over other solutions. The most important ones include the following.
a) Improves cash flow
Construction factoring is designed to improve cash flow problems caused by slow-paying customers. It can improve cash flow quickly, usually shortly after deployment.
b) Simpler qualification
The program has simple qualification criteria. It is easier to obtain than conventional bank financing and has fewer covenants.
c) Quick deployment
Factoring lines can be deployed quickly. Most lines can be deployed in a week or two as long as the finance company gets all the information they need promptly.
d) Simple line increases
The factoring line is tied to your sales to high-quality commercial customers and general contractors. The line can be increased quickly, provided your customers have good business credit, and your company can deliver the products and services.
5. Limitations
Construction factoring is not for everyone. The program has some limitations that construction companies must keep in mind.
a) Available only to subcontractors
The program is available only to subcontractors. Unfortunately, construction factoring companies cannot finance General Contractors.
b) Cannot finance residential clients
Factoring can be used only to finance invoices due from commercial clients or GCs. It cannot be used to finance invoices from residential clients.
c) Your clients must have good business credit
The program uses your invoices as collateral. Consequently, it can only finance invoices payable by commercial clients and GCs with good business credit.
d) It can be expensive
Construction factoring is comparatively expensive. It should be used only by companies with higher profit margins.
6. Qualification criteria
The qualification requirements for construction factoring are simpler than the requirements for other products. Your company must meet the following six criteria.
a) Must be a subcontractor
The program is only available to construction subcontractors. Unfortunately, construction factoring is not available to general contractors. This is due to the complexity of supplier payments and lien management.
b) Must work with commercial clients or GCs
You can only finance invoices from commercial clients or general contractors. Your clients must have good business credit because their invoices are the primary collateral for the transaction.
c) Can’t have a bond on the job
Note that there is no problem if the GC has a bond for the job. However, your company must not have a performance bond on the job. This is because the bonding company files a lien that prevents the factor from obtaining 1st position on your invoices.
d) Must not have open loans /cash advances
Your company cannot have any open loans or cash advances. This is because they typically encumber all your assets with a lien. Factoring companies need to have a 1st position lien against the invoices they finance.
e) Must meet the financing minimum
Most construction factoring companies have a minimum monthly volume. The minimum varies by company, but it’s typically set at $50,000/month. Your company must invoice more than the monthly minimum to qualify.
f) No serious tax or legal issues
Your company must not have any serious tax or legal issues. If it has any issues, you should have a workout or resolution plan in place.
Get more information
Are you looking for a factoring quote? We provide construction factoring at affordable terms. For more information, get an online quote or call us toll-free at (877) 300 3258.