Construction subcontractors often encounter cash flow problems while waiting for a client’s payment. This situation happens because most commercial clients and general contractors pay their invoices in 30 to 60 days. However, as a subcontractor, you have expenses you must pay right away.
One way to solve this problem is to finance your invoices from progress payments. However, finance companies avoid working with construction progress payments because they are labor-intensive and have a higher risk of non-payment. One alternative to finance progress payments is to use construction factoring. This type of financing is designed to work with progress payments. In this article, we discuss:
- What is a progress payment?
- Why are progress payments difficult to finance?
- Financing progress payments with factoring
- Advantages and disadvantages
- Qualification criteria
1. What is a progress payment?
In construction, a progress payment is a partial payment that covers the amount of work that has been completed up to the point of invoicing. There are several ways to structure these types of payments. The most common ways of progress billing are:
- Billing by stage
- Invoicing by the percentage of completion
For example, a subcontractor using the percentage-of-completion method could send an invoice when 30%, 60%, and 100% of the project is completed. On the other hand, a subcontractor who invoices by stage sends their invoices when specific project stages (e.g., all drywall installed) are completed.
2. Why are progress payments difficult to finance?
Progress payments in the construction industry are difficult to finance because they are often subject to disputes and “pay when paid” clauses. These two issues increase the workload and the risk for the finance company, which is why most finance companies avoid the construction industry.
Invoice disputes are common in the construction industry. Subcontractors and general contractors often disagree about the amount and quality of work that has been completed. These disagreements delay invoices, take time to resolve, and often leave all parties with less than they expected.
b) Pay when paid
Many construction projects that use a general contractor (GC) have “pay when paid” clauses in their contracts. These clauses allow the GC to pay their subcontractor after the end-client pays them. This clause can be the source of many problems when progress payments involve work done by many subcontractors. The GC’s payment could be delayed due to issues with another company’s work. Unfortunately, there is little a subcontractor can do in these situations.
Additionally, there are also situations where GCs can delay (or withhold) a subcontractor’s payment even though the end customer has already paid. GCs can do this as a negotiation tactic or if they have cash flow problems.
3. Financing progress payments with construction factoring
One way to finance progress payments is to use construction factoring. Construction factoring is an industry-specific type of invoice factoring. These programs can finance progress payment invoices that are due to be paid in 30 to 60 days. This type of financing provides the subcontractor with immediate funds to pay suppliers and employees and to run their business. Construction factoring is offered by specialized factoring companies.
a) How does factoring work?
Invoices for progress payments are financed in two installments. The first installment is called the advance and covers 70% to 80% of the invoice. This installment is deposited to your bank account once your commercial client or GC has verified that the invoice is approved. The second installment is deposited to your bank account, less the cost of service, once your client pays the invoice in full. Learn more about invoice factoring and how it works.
b) How are “pay when paid” clauses handled?
Factoring companies can only finance invoices that meet these criteria:
- Work for the progress/segment has been delivered
- Commercial client/GC has accepted the work
- Invoice will be paid in 30 to 60 days
A “pay when paid” clause affects #3 because the factoring company can never know when the invoice will actually be paid. Factoring companies address the issue by asking the GC to sign an “acceptance and payment” letter during the verification process.
The acceptance and payment letter states that the work segment has been completed, is acceptable, and will be paid in 30 to 60 days. When the GC signs this letter, they are effectively waiving the “paid when paid” clauses attached to your payment.
Most construction factoring companies will not finance an invoice if the GC does not sign an acceptance and payment letter. Consider discussing this letter with your GC ahead of time to get their approval.
4. Advantages and disadvantages
Factoring programs have a number of benefits and a few disadvantages. Advantages of factoring programs include:
- Improves your cash flow
- Available to small and growing companies
- Easier to get than conventional financing
- Grows with your sales
However, construction factoring does have some disadvantages as a solution:
- More expensive than conventional financing
- Requires the GC to sign an approval letter
- Only solves cash flow problems due to slow invoice payments
5. Who can use construction factoring?
Qualifying for factoring is simpler than obtaining other financing solutions. Some of the qualification criteria include:
1. Work with reputable commercial customers or GCs
2. The GCs or commercial client must have good business credit
3. Your profit margins must be over 15%
4. Your invoices should not be pledged as collateral to other lenders
5. Your company should not have an open bankruptcy
This solution is available to subcontractors in most specialties, including
- Directional boring
- Utility construction
- Drywall companies
- Construction cleanup
- Most subcontractors…
If you are looking for a finance company, read “How to Choose a Factoring Company” for more detailed information.
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Are you looking for a factoring quote? We provide construction factoring at affordable terms. For more information, get an online quote or call us toll-free at (877) 300 3258.