Getting paid in construction can take a long time. It isn’t unusual for payments to take 60 days or more. When cash isn’t flowing into your construction business as quickly as you need it to, many contractors look at their accounts receivable. They’ll try to figure out how to get their customers to pay faster. If you need to improve your cash flow – and are willing to pay for it – a factoring or debt collection agency may be able to help. But what’s the difference between invoice factoring and collections in construction? And how do you know which option is better for you?
Factoring and collections are both methods of construction finance that help contractors get money from their invoices faster. If your clients usually pay within the payment terms, but it’s just not fast enough for you, then you can look at construction factoring. If you have clients that are past due in their payments to you, you can hire a collection agency to get as much as you can. The best choice depends on your situation and how quickly you need the money. Both options can be an important part of a contractor’s collection policy.
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Overview of Construction Factoring
Invoice factoring is a process of selling a receivable in exchange for an immediate cash advance. The process starts when you sell your invoices to the factoring company, and they give you a portion – typically 70-80% – of the money as an advance. Later, when the invoice is paid by your customer, you get the remaining balance, less the factoring company’s fees. This can be great if you have an immediate need for cash and don’t want to wait for your customers to pay you.
Most factoring companies will ask that you sign an on-going agreement to sell your receivables every month. These agreements may have minimum limits and fees if you don’t meet those limits. You may also look at spot factoring, which is selling small numbers of invoices as needed. It will cost you more than an on-going agreement, but may be just the boost your cash flow needs.
The fees for factoring cover several services. They can include an account set-up fee, wire fees for moving money from the reserve account to your account, mailing fees, administrative expenses, and monthly minimum fees if you fail to meet the minimum monthly limit.
Overview of Collections
When the GC doesn’t pay your invoice by the due date, it puts a strain on cash flow. Most of us don’t have time to constantly contact our customers to try to collect on late payments. Repeatedly calling and mailing statements can be extremely frustrating. Sending a customer to collections is often a last resort for contractors trying to collect payment.
Collection agencies generally operate in one of two ways. They can either:
- Collect the outstanding debt on your behalf
- Buy the debt from you
In the first option, the collection agency will contact your customers about their late payments and try to get them to pay you. They keep a portion of any amount that is collected, and you aren’t guaranteed that the full debt will be paid.
If they buy the debt (i.e. old invoices) from you, then your relationship with them is over. It’s a simple transaction. They will chase down your former customer and try to get as much from them as possible.
Video: Construction factoring vs. debt collection
Similarities between factoring & collections
They buy your invoices for completed work
Factoring companies and collection agencies can both buy your outstanding invoices or pay applications. In fact, that’s their whole business model. They exist to get your debts paid. However, both of them only buy a valid invoice. You have to have completed the invoiced work before they’ll give you money for it.
They don’t care about your credit score
Because factors and debt collectors want your invoice to get paid, they don’t care about your ability to pay your bills. Instead, they care about your customer’s ability to pay. Your credit history or credit score won’t affect the rate they charge.
They take A/R off your plate
Both can take over your accounts receivables, and all of the processes that go with it. They will contact your customers and send reminders to encourage your customer to pay their bill.
The difference between factoring and collections
Factoring gives you cash up front
A factoring company will buy your invoice or pay application anytime before it’s due, even as soon as you issue it. They can provide you most of the money immediately.
If they’re buying your old debt, a collection agency might give you cash up front, too. But you will only get a tiny fraction of the invoice amount. More commonly, an agency will collect on your behalf, and take over the communication with your customer. In this case, you don’t get paid until the collection agency gets the payment from your customer.
Factoring doesn’t handle old debt
Factoring companies and collection agencies can both help your cash flow situation when you’re in a bind. But they are each useful at different points in time.
A factoring company only wants your new debt. That is, your invoices that are not past their due date. You can sell your invoice or payment application to a factoring company as soon as you issue it.
A collection agency, on the other hand, generally only deals with invoices that are past due. In a way, they are trying to achieve the impossible. They are attempting to collect on a debt that you have decided is uncollectible.
Factoring is only for your good customers
Collections agencies generally deal with your bad customers – contractors or property owners that don’t pay on time, if ever. It’s a risky proposition. If the invoice is already 60, 90, or 120 days past due, it’s going to be difficult to get that customer to pay.
Factoring companies only want to deal with your good customers. If your GC has a history of paying late – or not paying at all – a factoring company might refuse to buy their invoice or they will charge you more when they fail to pay. They charge a much lower financing rate because the risk of nonpayment is very low.
Factoring is less expensive than collections
Because collection agencies deal with riskier debt, they charge more. A lot more.
Depending on the service you get, a collection agency may charge anywhere from 20% to 80% of the amount recovered. You may end up getting only a fraction of what you are owed. Granted, this is better than nothing, but it isn’t much for your hard work.
The rate that factoring companies charge tends to be much, much lower. Factoring companies will typically take 1-3% of the invoiced amount, and you get a portion of it right away. With cash in hand, you can pay your employees and suppliers on time, or use it to purchase new equipment or pay off debt.
In fact, it can be one of the cheapest financing options available to construction businesses. This is largely because they’re dealing with low risk debt. They have done their research into the GC, and are very confident that the customer will pay your invoice on time.
They affect relationships in different ways
Because collection agencies charge hefty fees to collect bad debt, there are plenty of predatory agencies that give the collection industry a bad name. As a result, few contractors enjoy getting a call from a debt collector. Of course, not all collection agencies are created equal. There are collection agencies out there that will collect on your behalf with integrity and courtesy. (Just see this list of the top collection agencies for construction businesses.) If you need a debt collector’s services, it’s important to find one that values your relationship with your customers as much as you do.
Most of the time, a factoring company doesn’t get actively involved in trying to collect, since the debt is low risk and usually paid within terms. They often simply wait for the payment and then disperse the remaining funds to you. However, just like collection agencies, every factoring company is different. Some use annoying robocall reminders to your customers, while others take a softer, more personalized approach. Understanding how the company approaches the contractor will help you choose the right one.
Construction Factoring or Collections: Which is Better?
Construction companies may need the services of both companies, but at different times. Whether you use factoring or collections to help you with your cash flow depends on where you are in the invoicing cycle, and when you need the money.
If you have receivables that are within their payment terms and the client has a history of paying on time, you can sell those receivables to a factoring company. They will send you an immediate advance for a majority of the amount, then send you the balance, less fees, when the client pays.
If you have clients who are late paying, and you aren’t sure if they will pay you at all, then a collection agency may be your answer. They will attempt to contact the client and arrange for payment. This takes the collection issue off your plate and allows you to get back to what you do best.