Pay-when-paid clauses are common in construction contracts. Unfortunately, they can complicate invoice factoring transactions because they introduce additional payment risks.
This article explains how pay-when-paid clauses affect construction factoring, why they are challenging for factoring companies, and how construction factors manage these risks. We cover the following:
- What is a pay-when-paid clause?
- How do pay-when-paid clauses affect factoring?
- Requesting a waiver
- Better underwriting and due diligence
Note: This article assumes you are familiar with construction factoring. Read “What is construction factoring? How does it work?” to learn more.
1. What is a pay-when-paid clause?
A pay-when-paid clause is a contractual provision that specifies that a general contractor (GC) will pay a subcontractor after the GC gets paid by the project owner. General contractors use these clauses to protect their cash flow, especially during large projects with multiple contractors.
These clauses determine when the payment can be made. However, they usually do not remove the GC’s obligation to pay their subcontractors. The GC still has the responsibility to pay you even if the project owner fails to pay them. Keep in mind that your contract’s specific terms and applicable law ultimately determine the GC’s payment obligations if the project owner fails to pay.
2. How do pay-when-paid clauses affect factoring?
Most conventional factoring companies avoid financing invoices with pay-when-paid clauses due to their high risk of nonpayment. However, construction factoring companies finance these invoices regularly and are well equipped to manage this risk.
The factoring company’s primary concern is payment uncertainty. The pay-when-paid clause introduces a new contingency into the payment process by making payment dependent on the project owner.
Consider the following situation. A GC may be financially sound and have excellent business credit. However, they can still delay payment until the project owner pays. This makes it difficult for the factoring company to determine if or when it will collect the invoice.
Construction factoring companies approach this situation in one of two ways. Some factors manage this risk by requiring that the GC sign a document waiving the pay-when-paid clause. However, many construction factoring companies are taking a different approach and no longer rely on a waiver. Instead, they manage the risk through underwriting. The next two sections cover each strategy in more detail.
3. Are GC waivers a practical solution?
Construction factoring companies can reduce the risk of pay-when-paid invoices by requiring the GC to sign an agreement waiving the pay-when-paid clause. The factor won’t finance any invoices that aren’t covered by the waiver.
The exact wording of the document varies by factoring company. Some use very simple language, while others include detailed estoppel provisions designed to prevent the GC from later disputing the invoice or its obligation to pay.
Although GC waivers can be effective, they also have limitations. We see three main problems with this approach:
a) GCs dislike these letters
General contractors dislike receiving these letters and have little incentive to sign them. Furthermore, signing the letter typically requires them to give up contractual protections without receiving anything in return. From the GC’s perspective, there is little reason to modify an existing agreement simply to accommodate the subcontractor’s factoring arrangements.
b) It can affect the subcontractor’s reputation
Subcontractors depend on maintaining good relationships with GCs to secure future projects. A GC may be less likely to hire the subcontractor again, especially if there are other subcontractors who can provide the same quality work without asking for special terms.
c) They don’t work as well as expected
While GC waivers can be effective, they don’t always work as well as expected. Their enforceability depends on several factors, including the document’s wording, the circumstances under which it was signed, and applicable law. Lastly, enforcing the agreement to collect payment could involve expensive litigation, with no guarantee of a favorable outcome.
Note: Requesting a GC waiver of a pay-when-paid clause is different from routine invoice verification, which is a standard part of the factoring process.
4. Managing risk through underwriting
Some construction factoring companies use a different strategy to manage the risk associated with pay-when-paid invoices. They don’t require GCs to sign a waiver. Instead, they have adapted their due diligence process to manage the risk more effectively.
The factoring company’s due diligence focuses on the subcontractor’s performance history and the GC’s payment and litigation history.
Subcontractor’s track record: The subcontractor must have a history of successfully completing projects and receiving payment. This helps establish its experience and ability to fulfill its contractual obligations.
GC’s payment history: The GC must have a proven record of paying subcontractors on time. It should also have no significant history of lawsuits involving nonpayment on construction projects.
Transactions where both the subcontractor and the GC have strong track records are more likely to be approved. On the other hand, transactions where either party does not have a strong track record are likely to be declined.
We prefer this approach because it allows us to evaluate each transaction on its merits rather than automatically rejecting invoices with pay-when-paid clauses or requiring GC waivers.
Note that this does not mean that the factoring company will never ask a GC to sign a waiver. Although unusual, a waiver may still be requested for certain transactions with a complex risk profile.
a) What if the subcontractor has a limited track record?
A limited track record does not necessarily prevent a subcontractor from qualifying for financing. For example, a company that’s only been around for six months and has completed four projects may appear to have a limited track record. However, it could still qualify.
On the other hand, a brand-new construction subcontractor with no prior experience or completed projects is unlikely to meet the underwriting requirements. In practice, these situations are relatively uncommon.
Can we help you?
We are a leading construction factoring company and can provide you with a competitive proposal. For more information, get an online quote or call us toll-free at (877) 300 3258 to speak with an expert.
Marco Terry is the Managing Director of Commercial Capital LLC and has over two decades of experience in asset-based finance. He has worked with small and mid-sized companies across the United States, Canada, and Australia. Marco holds a Master of Science in Finance.