What Is a Financing Contract And How Does It Work?

Sometimes, companies have the skills and competence to complete a profitable contract. However, they lack the sufficient financial resources required to complete the project. Under such circumstances, it can be a good idea to enter a financing contract.

Such type of financing is mostly used in the construction industry. The majority of construction contract payments are made through the completion of milestones throughout the Contractor at the end of the project.

Both approaches require business owners to devote their own funds to preparing and executing a specific project.

The construction companies need funds to perform various tasks such as analyzing,  data, collection and sourcing materials, labor, tools, machinery, etc.

The customer may even cancel the contract if the company is unable to raise the funds it needs to perform or complete the contract. Further, progress towards the completion of the project is tracked with milestones and payments.

There is a difference between contract financing and conventional loans: contract financing is underwritten based on contract terms. On the other hand, a conventional loan is mainly based on your credit history.

Explanation For Contract Financing

If a business has already won a customer contract and is ready to fulfill it after funds become available, it has the option of contract financing. It is possible that a contract can be sought for financing well before it is awarded.

The majority of the companies go for this approach. In this approach, engaging the companies to own funds is restricted to the minimum.

And all the finances that are used for the completion of the Contract are funded by a third party. In this case, the third party are mainly banks and investment companies. These companies fund the projects for a return that allows them to earn.

How Does Contract Financing work?

Typically, a contract financing company advances almost 90% of an invoiced amount right away. It means that if your business has completed a milestone, you’ll be able to raise 90% of the invoiced amount of completed work.

So, the liquidity advantage is that you have immediately received the invoiced amount rather than waiting for the days and months under-invoicing terms. And the proceeds raised can be used to finance the next milestone.

So, the companies that operate under contract financing can use the Contract as collateral to obtain funding for a specific project.

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In this case, the company receives partial payments based on the amount billed for completed portions of the project.

Similarly, financing can also be raised to finance the first milestone. However, in this case, the financing companies seem to be more focused on your business’s ability to perform the contractual obligations as there is more risk.

The more risk is due to the fact that work has not been performed yet under contract.

Likewise, small or medium businesses with a poor credit history can be unable to access conventional bank loans and commercial lines of credit.

But when it comes to contract financing, there is a totally different alternative that is being offered to the companies seeking funding for performing specific tasks.

Such financing is more easily approved if the following conditions are met:

  • The credit rating of your client is excellent.
  • With a signed contract and an explicit schedule for payments and milestones, you clearly understand what is expected and how to do it.
  • The financing company is confident in your ability to complete each milestone on time and on schedule due to your track record.

Getting a Contract Financing

The bank usually does not get involved in contract financing since it technically isn’t a loan. In lieu of traditional banks, private lenders specializing in factoring prefer lenders for this type of financing.

Most of these companies operate online, and accessing them is pretty easy. These online investing companies often offer a few different packages for the same funding.

There are three options that are put in front of the companies seeking contract financing. These options are stated below.

  • Contract financing
  • Accounts receivable factoring
  • Invoice factoring

These are the three main financing types available to a business seeking contract financing. Contract financing is not as tightly controlled as traditional banking; therefore, borrowers need to understand the details of funding offers before agreeing to a funding offer.

Qualifying for Contract Financing

There are many ways in which contract financing differs from conventional business loans. The principal difference between it and a secured loan is that contract financing is unsecured.

And due to this, the risk associated with this type of loan is higher than a traditional loan.

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Consequently, before approving a business loan, lenders may take more precautions and consider more factors than they would normally.

The following are the most significant factors that a lender will consider when evaluating a business for a contract loan.

  • The Credit Rating
  • Monthly Billing
  • Time in Business

The Credit Rating

Since the client is responsible for paying the loan, a lender will scrutinize the client’s creditworthiness before approving the loan.

When deciding whether to approve the client’s funding, the lender will review their credit history and business rating.

The financier may advance the company upwards of 90% of the invoice amount, mainly if the Contract is for a government.

Invoice payments are made according to the contract details. So, the financing company would want to know if the customer is good with money.

Monthly Billing

Borrowers’ average monthly billings constitute a significant factor in influencing how much loan can be approved.

In case the project client fails to pay the loan amount, the lender would like to know the business’s income each month.

Although the client’s contract secures this loan, the lender wants to know if the business will be able to repay the amount in a reasonable time, even without contract milestones or completion payments.

Time in Business

When it comes to contract financing, the length of the business’s existence is a critical factor. The risk factor of new businesses is higher than that of established businesses. This is because lenders consider it a major factor and becomes reluctant to lend to startups.

Businesses that have operated for more time are more likely to be considered for contract financing. However, their history of operations should be clean rather than being full of defaults and missed commitments.

Conclusion

Businesses may have the skills and competence required to comply with contract provisions. However, they might be lacking in financial resources.

In such circumstances, contract financing can be an excellent choice. It enables your company to raise finance at every milestone achieved. Your business does not need to wait for days and months to receive the funds under invoice terms.

It’s important to note that funds can also be raised when a customer has not been invoiced for the first milestone. However, terms need to be mutually agreed upon between the financing company and the business.

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The working mechanics of contract financing is that suppose your business completes milestones and sends an invoice to the customer.

However, you have 60 days terms with the customers. Such a situation might put you under the inability to perform further performance obligations in the Contract.

So, a good solution can be to opt for contract financing where your business will be able to raise 90% of the invoice raises. So, you remain liquid and continue achieving the next milestone.

In our example, the repayment is made when the customer pays off the invoice after 60 days. It’s like a customer will make a payment to the financing company, And it will be able to collect the loan amount, along with their fee.

It’s important to note that the repayment of a loan depends on the customer’s ability to pay an invoice. Hence, their financial credibility is important in getting approval for the financing contract.

Frequently asked questions

Can a business opt for financing a government contract?

Yes, Government contracts can be used as collateral to get financing. Government has more credibility to pay an invoice.

Hence, there is a lower risk from the perspective of funds collection. So, the financing fee in the case of Government contracts is expected to be lower than financing for private companies.

Give an example of contract financing.

Suppose your business has entered into the Contract totaling $100,000 and the Contract is divided into ten milestones each is to be completed and invoiced on a monthly basis. The payment for the invoice is to be made after two months.

So, once you’ve completed one milestone and invoiced $100,000, either you can wait for two months to receive the $100,000 or you can approach the financing company to disburse proceeds. The companies usually disburse up to 90% of the invoiced amount.

Alternatively, you may need to raise financing for the first milestone. In that case, financing companies can help as well. However, there seems to be a bit more risk in that case.

List the non-traditional sources of financing.

Following are some of the non-traditional financing.

  1. Peer-to-peer lending
  2. Crowdfunding
  3. Microfinancing
  4. Peer peer lending
  5. Working capital
  6. Bootstrapping