In the construction industry, it can be hard to access cash when you need it. Many small contractors don’t qualify for a business loan or line of credit from the bank, and credit cards are an expensive option. Invoice factoring provides a middle ground, offering cash to contractors backed by the value of their unpaid invoices. If you’re considering factoring for your construction business, you’ve probably heard of spot factoring and contract factoring – the two main factoring options. We’ll look at the difference between them, and the upside and downside of each.
What is invoice factoring?
Invoice factoring allows business owners to use their receivables, or outstanding invoices, to get cash before their customer pays the invoice. Sometimes called invoice financing, factoring is similar to getting a loan, with some key differences. In essence, factoring is when a company buys the invoice from you. This allows them to work outside of the regulation typical with traditional lending or other financing options.
After purchasing your invoice, factoring companies offer an advance rate – a percentage of the invoice offered as an upfront payment. The advance rate can range from 80% to 98%. After they receive payment from the customer, they subtract their cut and pay you the remainder. The fee that the factoring company charges is called the factoring rate, or discount. The factoring rate is typically calculated on a 30-day basis, and ranges from 1-5%.
Dig deeper: Learn more about the costs of invoice factoring in construction
Factoring is available after you submit an invoice for work you’ve already completed, and before it is paid. Generally, factoring companies will only factor an unpaid invoice for 90 days. If your customer is known for taking longer than that to pay invoices, factoring may not be an option.
For a small business that doesn’t have established credit or can’t access traditional financing, factoring is often an attractive alternative. Invoice factoring companies won’t run a credit check on you, or ask for financial statements. Instead, they look at the creditworthiness of your customer, and the riskiness of the invoice itself.
Why would a contractor want to factor an invoice?
If you have to ask, you probably don’t work in construction! It takes a long time to get paid in our industry – 83 days, on average. Anytime the owner or GC delays payment, the cash flow of everyone below them on a job will suffer. It could take weeks after a construction project starts for even a first-tier sub to receive their first payment. Subs have project expenses to meet while the GC, architect, and owner take time to review and approve the invoice. Factoring can give construction businesses an immediate cash injection as soon as they submit an invoice.
If companies don’t have sufficient cash reserves, that delay between invoicing and getting paid could be detrimental. That’s where invoice factoring comes in. Factoring can help subs cover expenses on a project before the GC or property owner submits a payment. The factoring company pays the sub most of the value of the invoice amount right then and there. After the invoice is paid and fees are deducted, the factoring company will pay the rest of the invoice to the sub.
Video: Spot factoring vs. contract factoring
Construction factoring: Spot vs contract factoring
The two main ways to factor a construction invoice are spot factoring and contract factoring. The difference is primarily one of volume. Spot factoring is generally used to get cash for a single invoice or pay application. Contract factoring, in contrast, is a longer-term agreement where you send the factoring company a certain percentage of all of your invoices.
Spot factoring
Spot factoring in the construction industry is when a contractor finances a single invoice, or several specific invoices. Subs can use spot factoring as a one-time service, or use it from time to time when needed. Spot factoring is typically a single transaction between the sub and the factoring company. This means there’s no expectation for future business. Contractors can view spot factoring as an option, not an obligation.
The upside of spot factoring
This method of factoring gives a sub the freedom to pick and choose which invoices they’d like to have funded. Another benefit of spot factoring is that, typically, there are no long-term contracts or monthly minimums. Spot factoring is a reliable solution for subs whenever they start to face cash flow problems on any project.
It’s especially useful for a construction company that has a good handle on their cash flow in general, but is looking to grow beyond their current capacity. If a contractor just won a large project that they don’t have cash reserves to cover, spot factoring the initial invoices may give them the cash flow they need to get through payment delays.
The downside of spot factoring
However, there are several drawbacks to spot factoring to consider. For instance, it’s more expensive than contract factoring. Because it’s a one-time service, the factor has only one transaction to recover working capital costs, due diligence costs, and to make a profit. As a result, the factoring fees tend to be higher. Spot factoring is typically available with a lower advance rate and/or a higher factoring rate.
Another downside to spot factoring is that they typically only work on large invoices. Because factoring is a volume-based business, profits are tied directly to the amounts that subs finance. Factors will finance a single invoice, but it has to be worth their time and effort.
Spot factoring can also cause communication problems with your customers. After a factoring company buys your invoice, your customers must send payments directly to them. It’s common for contractors to send payments to the wrong place, causing delays. Depending on how aggressively the factoring company tries to collect on the invoice, they can also cause a rift in your relationship with your customer.
Contract factoring
Contract factoring is essentially a longer-term agreement between the construction business and factoring company. Typically, the agreement requires the construction company to sell a certain percentage of all invoices to the factoring company. The factor may set a minimum dollar value that the contractor must factor in a given period.
Here’s an example: You sign a contract with the factoring company for a 12-month period. You agree to factor $2 million worth of invoices during the year. If you meet this threshold, your advance rate will be 98% with a factoring rate of 1% per 30 days. If you fail to meet it, you will pay a penalty.
You’ll sometimes hear companies refer to selective factoring. This is just another name for contract factoring, where you can select which invoices you want to factor. You may also select specific GCs or contracts whose invoices you want to factor. Of course, the factoring company still has to agree to factor each invoice.
The upside of contract factoring
Contract factoring is generally cheaper. Because the factoring company is handling a larger volume of invoices, they will offer better rates. Contract factoring typically comes with a higher advance rate and lower discount, or factoring rate. And there’s plenty of room for negotiation. Because the factoring industry isn’t regulated like bank loans, there is little oversight as to how the deals are structured. There is an almost endless variety of ways that you can set up a factoring contract that benefits to both parties.
In some cases, a contractor may decide to simply factor all of their invoices. This allows the factoring company to effectively take over their accounts receivables department. This often makes communication with your customers simpler, after they get used to the factoring process. The factoring company makes sure your customer pays the invoice. And your customer sends payments directly to the factoring company. It can take a lot of extra work off of your plate.
Dig even deeper: Factoring and collections aren’t the same thing
The downside of contract factoring
But contract factoring also has its own drawbacks. One such drawback is that subs won’t have as much flexibility with their factoring. If you don’t meet the minimum volume required by your agreement, you could face steep penalties.
Another disadvantage to contract factoring is that it always requires a contract with the factoring company. This means contractors will be locked into any fee or rate agreements for the life of the contract. If you don’t meet the contract minimums, it could cost you.
Spot vs. contract factoring? It depends on your priorities
Factoring can provide critical cash flow to construction businesses, particularly those that are out of reach of traditional financing options. If you have an unpaid invoice from a contractor or property owner who pays their bills on time, spot factoring can help you turn that invoice into cash that you can use now. If you’re looking to grow your construction company, contract factoring may be able to give you a regular cash infusion to take on bigger projects.