Contract financing turns your contracts into cash — allowing you to start and deliver on a new project.
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What is contract financing?
Contract financing, or contract finance, presents a way for businesses to get a cash advance — on work they’ve yet to commence or complete. The contract between a business and its customer, serves as security or collateral.
Contract financing enables companies to take on ambitious new projects, while being safe in the knowledge that, they’ll be able to immediately get the funds needed — to complete it.
A letter of intent (LOI) to fund, can be linked to a promise of contract financing. The LOI acts as a proof of financial capability — when tendering or bidding for a contract.
Contract financing is a great way of fulfilling government contracts, and is quite common in the construction sector. It can be seen as a form of working capital finance.
Contract financing — considerations
Although a company may be awarded a large private or government contract — the money is rarely advanced upfront. Contracts typically have milestones, at which funds are released — in preparation for the next stage of the project.
This can be a challenge for businesses or contractors needing to mobilize, begin, continue and complete projects. Supplies need to be bought, equipment must be paid for, and staff need to be hired — along with several other related expenses.
Contract financing is a solution to these problems — allowing businesses to either get paid up front, or as soon as an invoice has been raised.
With contract financing — the lending is underwritten based on both the creditworthiness of the end-customer, and the specific terms of the contract. Accordingly, when it comes to making lending decisions — less importance is placed on a contractor’s credit history.
It is for this reason, that contract financing is especially useful for SMEs and contractors — that have little to no credit history. This lack of, or poor credit history — often restricts access to conventional business loans and commercial lines of credit.
Although similar to invoice finance — contract financing differs. Invoice financing is concerned with businesses getting paid — after work has been completed. On the other hand, contract financing is focused on releasing working capital — based on interim progress (towards completing a project).
Further, contract financing may be structured in a way that includes other funding solutions e.g. an unsecured loan to fund mobilization efforts.
How does contract financing work?
If your company operates under contracts or is awarded a one-off large contract — you may seek an appropriate lender.
This lender would asses the contract, your customer’s ability to pay and your business’s capacity to deliver the project. Consequently, you’ll need to provide them with details of your business such as trading history, statement of accounts, proof of past projects etc. Similar information will also be sought on your customer.
Should the finance company agree to offer you the contract financing facility — they would state their terms. This will be things like, interest rates, discount fees, factor fees, commitments fees, service charges and more.
The exact arrangements you would have with the lender vary, but will typically involve you submitting invoices to the lender — as you complete each project milestone. Based on the value of this invoice, the lender may immediately advance up to 90% of the invoice amount. The remaining 10% will be paid to you, minus a discount fee, when your customer actually pays the invoice.
Some arrangements also involve the lender advancing funds, in the form of a “mobilization loan” — to get the project started e.g. money for setting up a base of operations. Other arrangements, particularly for more complex projects that involve import/export, may include bonding facilities, documentary credits and more.
It is important to study the terms of any agreement, as there could be extra charges to pay — for example if your customer delays making payment.
Benefits of contract financing
- Helps manage cash flow
- No collateral required
- Enables you to take on multiple projects at the same time
- Opens up new business opportunities
Limitations of contract financing
- Expensive form of financing — due to risks of non-payment
- Difficult to qualify for — unless you have somewhat of a track-record
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