Businesses that possess the resources and expertise to complete a contract but lack the funding to complete it may lose the contract. Generally, contract financing refers to receiving advance funding on a contract that has been awarded but has been incomplete. This article aims to inform you what contract financing is, what it entails, how it works, and what its advantages and disadvantages are.
What Is Contract Financing?
A contract finance arrangement allows businesses to get a cash advance on work yet to commence. A contract between a company and its customer is a form of security or collateral. Through contract financing, companies can take on ambitious new projects, confident they’ll be able to obtain the funds immediately – to complete them. Sometimes, a letter of intent (LOI) to fund links to a promise of contract financing. When tendering or bidding for a contract, a letter of intent serves as proof of financial capability. Quite common in the construction sector, contract financing is an excellent way to fulfill government contracts. Essentially, it is a form of working capital financing.
Contract Financing: How It Works
The contract financing option is available to businesses that have already secured a contract and are ready to fulfill it. It is not unusual for contract financing to begin long before awarding an agreement. An example is when the client requires proof that the business has the funds to complete the project. A business may be required to provide proof of funding before awarding the contract to a client requesting high-value or time-sensitive services. A lender may require this demand to ensure the completion of the project without delay or stalling due to insufficient funds.
When such a situation arises, the business may request a letter of intent to fund from the lender to win the contract. The letter’s purpose is to inform the client that if the company wins the agreement, the contract financing lender will advance funds to it. Lenders may require business documents and contract details before issuing letters of intent. It is common for lenders to request records such as business profiles, financial statements, and references from previous clients. The documents help lenders assess a business’s credibility, resources, and capability to fulfill its client contracts.
Contract Finance Costs
Although contract finance is usually a few percentage points above prime, it connects to the prime rate.
There are also the following costs to consider:
- Lawyer’s fees for setting up cession documents (in this case, the lender will own the contract)
- The lender may charge transaction or management fees if they manage the finances
- Lender fees associated with providing contract administration and project management services.
Pros Of Contract Financing
- Enhances cash flow management
- There is no need for collateral.
- It allows you to handle multiple projects simultaneously.
- Provides new business opportunities
Cons Of Contract Financing
- Non-payment risks make this form of financing expensive
- Unless you have some track record, it isn’t easy to qualify
How To Get Contract Financing
Generally, banks don’t get involved with contract financing since it isn’t a loan. For this type of financing, private lenders specializing in factoring are often the best option. Most of these firms are online or operate locally, often offering different packages of the same type of funding.
Business owners seeking contract financing can choose between contract financing, accounts receivable factoring, or invoice factoring. They control contract financing companies more than banks, so borrowers need to understand finer details before committing their businesses to fund.
