Cash flow is tight in construction. Payments come slowly, and that makes it hard to sustain a business — much less grow it. To combat this problem, there are a number of legal tools available, such as prompt payment laws, mechanics lien laws, and retainage laws, to name a few. There are some business-oriented tools available, too. One such tool is construction invoice factoring. Factoring can be an intimidating topic, but at its core, it couldn’t be simpler.
What is Construction Factoring?
Construction factoring allows a subcontractor to borrow against their receivables. Factoring is a process in which businesses (in construction – typically subcontractors) obtain cash advances for their invoices. When factoring a construction invoice, a construction company will assign its invoice to the factoring company. In exchange, the factoring company will provide the construction company cash on the spot.
Video: What is Construction Factoring?
How do you Factor Construction Invoices?
First, construction invoice factoring requires that a party providing work agrees with a factoring company to factor their invoices. Typically, a factoring company will agree to pay out 70-80% of the value of the invoice to the subcontractor well before payment would have otherwise been received. Then, the bill becomes the factoring company’s burden to collect. Once that factoring company is paid for the subcontractor’s work, the factoring company will pay the subcontractor that remaining 20-30% minus the factoring company’s fee.
Types of Construction Factoring
Generally, there are two primary ways to factor construction invoices – spot factoring and contract factoring.
Spot factoring refers to a “one-off” situation. When spot factoring, a construction business is factoring a specific invoice in order to float the cash they need right then. Spot factoring might make sense where the business generally doesn’t have a lot of cash flow problems, but a specific event or problem job causes a hiccup with financials. Spot factoring construction invoices tends to be more expensive than contract factoring, and it’s really designed to get a company out of a bind.
Through contract factoring, cash will be provided in exchange for each progress payment, much in the same way as spot factoring (but on a larger scale). Generally, the rate that the factoring company charges will go down when a larger number of invoices are in play. When utilized for the entire life of the contract, factoring construction invoices can assure steady cash flow for the duration of the job. Every time an invoice for a progress payment goes out, the construction company can get their hands on most of the cash at an earlier date.
Video: Why Should You Consider Factoring Your Invoices?
Why Do Construction Companies Factor Their Invoices?
Construction payments come slowly. By factoring invoices, construction companies are able to obtain payment for most of their invoice 20, 30, even 40 days earlier than they would otherwise. Plus, as long as a subcontractor’s factoring company gets paid in full, the subcontractor will only lose a relatively small percentage of the invoice when it’s all said and done.
Let’s look at some of the specific reasons that make construction factoring worthwhile for some construction businesses.
Let’s Talk Cash Flow:
Get in a Bind With Payroll & Overhead
We mentioned it above – cash flow can be erratic in construction. Unlike other industries, payment doesn’t come right after work is complete – and it’s not uncommon for payment to come months afterward. That means it’s often hard to keep cash reserves to smooth out payments for payroll and overhead. Employees, rent, and other bills can’t be paid at the same irregular schedule your customer makes payment. Thus, by factoring construction invoices, a large portion of the outstanding invoice can be paid up front which might be enough to float payroll and overhead.
Want to Bid on Larger Jobs
Cash comes in at irregular intervals but goes out at a steady pace. That make sit can be hard to grow a construction business. Taking on larger jobs can really stretch a subcontractor thin. But, without taking on bigger jobs, how else can the business grow? Some construction businesses (understandably) use factoring as a shortcut for growth.
Want to Bid on More Jobs
Much like the above, when a contractor or sub wants to expand their business, that may require bidding on a larger number of jobs. However, bidding on more jobs also means working with companies beyond the normal customers. When working with new customers, its natural (and healthy!) to be skeptical. By factoring construction invoices, some of the risks of slow payment can be hedged.
Need Cash to Buy Equipment
When construction businesses need new equipment, whether it be to grow the business or to replace something broken, it takes cash. If the business doesn’t have the reserves to shell out for new equipment, factoring an invoice or two might help create enough wiggle room to get it done. That way, the business won’t have to mortgage its assets.
Video: Invoice Factoring vs. Getting a Loan
Invoice Factoring vs. Getting a Bank Loan
Why would a construction business factor invoices instead of going to the bank for a loan? For those who have spent time in the industry, this is probably pretty easy to answer. Not to beat a dead horse, but cash flow isn’t exactly smooth in construction. It’s herky-jerky. Banks don’t exactly love that. What’s more, due to that erratic cash flow (or other problems that may pop up), it’s not all that uncommon for a construction business to have a questionable credit history. Banks don’t like that either. Plus, when dealing with a bank, there’s a lot of paperwork and red tape.
Factoring companies stage themselves as an easier option. There’s less red tape to cut through when factoring construction invoices, and the credit history of the company who’s factoring their invoices is largely irrelevant. After all, the factoring company is relying on the customer to make payment. As long as that customer isn’t a huge risk, a factoring company probably won’t object. Further, when a bank lends money, it requires assets as collateral until the debt is paid off. In contrast, a factoring company will make an upfront payment, and in exchange, it will collect the payment that’s due. No assets get encumbered (other than the invoice(s) which are signed away).
It’s not hard to see why a construction business might decide to factor invoices over going for a traditional loan in order to grow or stabilize their business. However, by factoring construction invoices, these companies are literally selling themselves short and denying themselves the opportunity to be paid in full for the work they perform.
Factoring vs. Debt Collection
A factoring company is similar to a collection agency in that they both provide invoices for work that you’ve already completed. And neither one cares that much about your credit history. In fact, they care much more about your customer’s credit, and their ability and willingness to pay. But in practice, factoring and collections are quite different. They both ease your cash flow problems, but they operate at opposite ends of your invoicing process. Factoring companies only want to buy invoices from your good customers. They’ll typically give you cash for an invoice as soon as you issue it, or before it’s due. A debt collection agency, on the other hand, typically gives you cash for invoices after they are past due.
Is Construction Factoring a Silver Bullet for Cash Flow Problems? (No.)
Factoring a construction invoice can be a useful tool for a business in a bind. It might even be a long-term tool for some construction businesses to steady cash flow while growing the operation. But construction factoring isn’t as easy as snapping your fingers, and it isn’t a good fit for every construction business.
For one, the factoring company has to make money too. It isn’t a charity. This isn’t to say that factoring companies are greedy – there’s lots of risk in construction payment, and they’ve got a business to keep up. However, when the factoring company has to get their cut, that can take several points off the profit margin for a job. As everyone knows, industry margins can be tight, to begin with.
Further, factoring companies are typically pretty wary of entering the construction space in the first place. There’s a whole market of businesses from other industries who are willing to factor their receivables that have much steadier cash flows and payment terms than in construction. So, even where a construction business has decided to factor their invoices, it might not be so easy to find a factoring company willing to work with them.
Improve Cash Flow (and Relationships) with Preliminary Notices & the SET Method
Factoring construction invoices is useful, especially in a pinch. But a long term, sustainable method for speeding up payments and building relationships is to SET a job up for success. The SET method means:
- See everybody
- Exchange easy paperwork
- Talk it out when a dispute arises
Video Summary of the SET Method
By sending preliminary notices, a job is started off on the right foot. Your customer, the prime contractor, and the property owner all feel safer knowing exactly who is working on their job. Plus, if an issue does pop up, they know who to talk to. That, and for businesses who send prelims, if they need to later talk to the prime or the owner about an issue, they’ve already acquainted themselves and they aren’t coming out of the blue. This is a crucial part of the relationship building process, and establishing this repertoire helps to avoid payment disputes in the first place.
By using easy paperwork, much of the tension and uncertainty that comes with construction payment goes out the window. Risk-shifting contracts don’t do much to prevent disputes from happening, and friendly, clear, concise paperwork helps to build trust. When parties can trust each other, they can collaborate more easily – and collaboration kills payment disputes.
Finally, when a problem does arise (and they will!), talking it out should always be the first step. Again, this helps to build trust – owners, contractors, and project managers don’t want to work with claim-happy subcontractors and suppliers. Rather, when there’s mutual trust that both sides will come to the table and talk out potential issues, there’s less anxiety about releasing payment down the chain. When payments can be released more quickly, the cash flow problems that necessitate regularly factoring construction invoices fall away.