Financial success for a construction business depends entirely on their ability to manage cash flow. When a contractor starts a new project (and throughout its lifetime), they face a significant outlay of cash — often months before they will ever collect a cent. Banks and other traditional lenders often consider construction too risky to finance. So how can contractors access capital when they don’t have the savings to cover expenses? In this article, we’ll explain the basics of contractor financing, and provide options that give you the freedom to close a sale without worrying about how you’re going to pay for it.
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What is contractor financing?
Contractor financing refers to the process of managing the flow of cash, both on projects individually and for the business overall. Because construction is a credit-heavy industry, the collection cycle for contractors can take weeks, months, or even years.
Construction businesses pay for labor, materials, equipment, and other inputs well in advance of collecting the funds necessary to cover the cost. As a result, contractors need to finance those expenses using another stream of funding while they wait for payment.
Contractors can secure financing from a variety of sources, whether internal or external. Unfortunately, because of the financial risk inherent to the building industry, the external funding options available to construction companies are often either less readily available, or much more expensive to secure when compared to other types of businesses.
Contractors can use financing to bring in cash — or delay payment for expenses — to bridge gaps in cash flow.
Financing can help contractors pay for job specific expenses and overhead business expenses. Some financing options are specific to the type of expense they cover, while others can be used to pay for any business expense.
Many financing options and their associated costs are based on the creditworthiness of the company and its principals. While most general business financing assesses risk using traditional tools (like your credit score), these haven’t served the construction industry well. Increasingly, contractor financing providers are getting more creative about how they measure risk, making capital available to a wider pool of applicants.
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The risk & cost of financing
The construction industry has long been viewed as too risky by traditional lenders — and for good reason. Payments on a construction project depend on so many factors that are outside of a single contractor’s control, and it has been difficult for lenders to reliably determine their credit risk.
Because the market has historically been underserved, a number of predatory companies have popped up to provide “loans” that aren’t governed by financial regulations. These companies use slick marketing and bold promises — but end up costing contractors way more than they think.
Contractor qualification for outside financing
Getting qualified for financing essentially involves convincing a lender that, if they give you cash, you will pay it back. The industry is making significant advances in the way financial risk is calculated. Lenders are now able to get a clearer picture of the financial health of a contractor — and the project they’re bidding on — by looking at the payment practices of the other contractors on the job, the property owner, and construction-specific forms of payment security (like whether the contractor is protecting their mechanics lien rights).
A review of a contractor’s financial statements is still the number one way that most lenders decide whether to provide financing. They provide a snapshot of the financial health of a company. A lender will assess whether the contractor has enough cash flow to make regular payments on a loan, and whether they have assets that the lender can go after in the event of a default.
Financial records that are audited by an outside accounting professional will always carry more weight than those prepared in-house.
Business credit history
Commercial credit bureaus provide credit reporting services for businesses — but very few small companies will have a record to pull from. Contractors will need to build a credit file over time. You can do this by opening a credit account with an agency like Dun & Bradstreet or Experian Business.
But even if you don’t open a credit file, you may still have some data in your report. Public records, like liens and UCC filings, will often show up. If you have a business credit card, that company also sends payment information to your file. And many building material suppliers report to credit bureaus, so it’s important to ensure that, if you purchase materials on credit with a distributor, you’re making payments on time.
Personal credit history
If a contractor doesn’t have the financial records or credit report to qualify for financing, the business owner may be able to secure financing by using their own personal credit history.
While certain payments to creditors may be included in your business’s credit file, others won’t — like payments to your subcontractors (and suppliers, if you aren’t purchasing on credit).
However, a contractor’s payment history on past projects can tell a potential creditor a lot about the borrower’s creditworthiness. If you have a string of liens filed by subcontractors on recent projects, it’s highly likely that you have a cash flow problem that’s keeping you from making payments — and that you aren’t a good candidate for financing.
Collateral & security
Securing financing to purchase a specific asset, like a backhoe, truck, or other construction equipment, is pretty straightforward. In most cases, the lender uses the asset as collateral for the financing, since they can (theoretically) repossess and resell it if you fail to make the payments.
Getting funding for project-specific expenses — like mobilization costs or materials — can be trickier, because there’s no collateral that the lender can sell if they can’t collect. You may have a $10 million construction contract, but because of the prevalence of payment disputes and delays in the industry, financial institutions have a hard time trusting that a contractor will actually be able to collect — and pay them back.
However, nearly every construction business has a powerful form of security in the form of a mechanics lien. Because a contractor’s lien rights give them the ability to file a claim on the property if they aren’t paid, it is a virtual guarantee to potential lenders that they will have the cash available to repay their debt.
While most traditional lenders (like banks) don’t consider a mechanics lien a valid form of payment security, many financial providers are starting to use lien rights as a tool to underwrite funding.
Types of financing for contractors
There are a wide variety of options when it comes to financing for contractors. Many depend on what the money will be used for to determine the type of financing available.
Financing for labor and overhead
Contractors can often finance general business expenses, like labor costs and overhead expenses, through a bank loan or line of credit.
Bank loans can cover a variety of business expenses for contractors, but qualifying for a loan typically requires prepared financial statements and a good credit history. The better your history and financials look, the more likely you are to qualify, and the lower your interest rate will be. The money is often paid back by monthly payments starting a few months after the loan is made.
If you’re having trouble getting a traditional bank loan, a Small Business Association loan may be for you. These loans are backed by the federal government, so the requirements are a little more lenient. There’s more paperwork, and you have to show that you’ve been denied a traditional bank loan. SBA loans are facilitated by local banks, which makes the application and loan process convenient.
A line of credit is essentially a loan issued to you by your bank, but you only take out the amount that you need when you need it. You have to apply for a line of credit before you need one, and it’s a good idea to do this if things are going well. That way you’ll have it in place when you need it. It’s easy to use as you just continue to spend from your regular checking account and the line of credit covers the overdrafts. The money does have to be repaid, and the terms and cost will be based on your credit and financial history.
Financing for equipment
If you’re looking to expand your fleet of equipment or vehicles, you can apply for an equipment loan or automobile loan. Most construction equipment dealers offer three financing options to contractors who need equipment: lease, lease-to-own, and purchase financing.
Most of us are familiar with asset-backed loans, as we use them to purchase our personal vehicles. Financing is provided by local banks through the dealer or manufacturer you are purchasing from. It requires a credit check, but the process is pretty simple. Payback is spread over months or years, allowing you to avoid a heavy cash outlay upfront.
Another option is to use proceeds from other loans, such as a bank loan or SBA loan, to cover the cost of purchasing equipment. In this case you would pay the dealer or manufacturer in cash for the equipment, saving you interest costs on a vehicle or equipment loan.
Financing for materials
The construction supply chain is among the most credit-heavy industries in the world. Very few contractors have enough cash on hand to purchase job materials up front, so construction suppliers rely on financing to make sales.
Contractors have a few options to borrow money for material purchases at the beginning or during jobs. You can apply directly to your supplier for a credit account, use a material financing company, or rely on company credit cards.
Nearly all building material suppliers offer qualified customers a trade credit account to finance materials for the short-term. You apply for credit directly from the vendor you buy the materials from, they review your credit history, and decide whether to issue credit. Payments are typically delayed for 30 to 45 days, allowing you time to get the cash together.
Material financing companies provide longer-term loans that are specifically used for the purchasing of materials. You apply for a loan from a finance company, which checks your credit, and if you’re approved, they pay the material supplier directly for your purchase. These companies generally offer a longer term to pay back the loan, some as long as 120 days. This solution is great if you know that payments will be delayed due to bureaucracy or a slow paying customer.
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Financing for project mobilization
Mobilization costs are all of the expenses required to get work started on a project. This cash outlay comes well before any invoices are submitted or payment is received, so it can cause a lot of stress to a company’s cash flow.
Because every project is unique, and traditional credit tools aren’t very good at assessing project risk, it can be difficult for contractors to cover mobilization costs without going into debt.
Fortunately, some companies have stepped in to provide support for these types of expenses. Mobilization Funding provides financing to contractors that can be used to cover initial and ongoing expenses on a job: materials, payroll, supplies, insurance, bonds, and equipment.
Other contractor financing options
Aside from outside loans and financing, there are some other options contractors can use to help finance projects and expenses.
Credit cards are a popular tool to fund expenses: 79% of construction companies use credit cards to purchase materials at least occasionally, according to a 2021 survey. Some even provide incentives that contractors benefit from (as long as they use the card wisely). They are easy to get and easy to use, and most vendors will accept payment. If you need a high credit limit to fund purchases, you’ll need a good credit history and good financial statements. Interest rates are usually higher with credit cards than other forms of financing, so you may want to do some research before using them.
Retained earnings, or the profits you’ve saved over time, can be used to fund both project and business expenses. The key here is that you need to have the cash available to use. Funds can be stored in short-term investments or savings accounts to provide ready access while still earning a small amount of interest.
Invoice factoring involves selling your current accounts receivable to a company in exchange for early payment on a portion of the balance. You receive 70 to 80% of the invoice amount upfront, and the remaining balance, less the factoring company’s fee, once the customer has paid the factoring company.
The benefit of using factoring is that your credit doesn’t come into the picture. The factoring company will be looking at your customer’s payment history, not yours.
A merchant cash advance, also called a daily debit loan, is a pseudo-loan that isn’t regulated by usury laws in some states. As a result, they can be expensive and incredibly risky, especially for construction companies that don’t have the cash on hand required to meet the daily withdrawals.
How to determine when to seek financing
Just because your bank balance is getting low and cash isn’t coming in doesn’t mean that you should seek financing. Often, cash flow problems in construction are really caused by slow payments from customers — and payment delays bring additional costs that can eat into a company’s bottom line.
There are lots of reasons why construction payments are slow, including onerous paperwork requirements and the many layers of contractors and vendors involved. The best thing you can do is to protect your right to receive payment through a mechanics lien and have a strong collection policy that you follow consistently for every customer.
Financing should be used for planned expenses that are geared toward growing your business. Things like adding to your labor force, taking on larger projects, or adding vehicles and equipment can all help you expand. Make sure that you have a plan for repaying the loan or financing, or you’ll run into trouble down the line.
Ensuring consistent cash flow is the goal of every contractor. You can do that through protecting lien rights, being proactive in your collection efforts, and having a consistent pipeline of work.