Contract Financing: What is It and How Does it Work?

Contract Financing: What is It and How Does it Work?

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Contract financing is a way for your business to receive a cash advance on work you have yet to perform. It is collateralized by a contract between your company and your customer. The contract specifies milestones and payments based upon your progress toward completing the project. Contract financing differs from loans from a bank or an online lender in that it's underwritten based on the terms of the contract and the creditworthiness of your customer, rather than being based on your company’s credit record.

How Contract Financing Works

Contract financing advances most of an invoiced amount right way, with the remainder—less a fee—paid to you when the invoice is paid. It is a tool used by companies that operate by contractually agreeing to perform services or produce products for a specific project or event. Frequently, the contract specifies the partial payments you’ll receive as you invoice for the completed portions of the work. The arrangement allows companies to avoid waiting months to, potentially, receive payments on invoices they submit directly to the customer.

For example, suppose your company constructs warehouses, and a customer hires you to build a new property for $600,000. You sign a contract that specifies six milestones with tasks and deadlines, each of which pays $100,000 upon successful completion. Since you know that this customer takes 60 days to pay after receiving an invoice, you decide to seek financing with a contract financing company that charges a factor fee of 2% for an advance term of 60 days.

The finance company will evaluate the contract, your business’s ability to deliver, and your customer’s creditworthiness. If it approves the arrangement, it takes over the project invoicing. You submit your invoices to the finance company as you complete each milestone. In this example, the finance company’s advance percentage is 90% of the invoice amount ($90,000), and this is paid on the day after submission. The finance company forwards the invoice to your customer, and pays you the remainder ($10,000), less a factor fee, when the customer finally makes the payment two months later. The fee is 2% of $90,000, or $1,800, so you receive $8,200 ($10,000 - $1,800) when your customer pays the invoice amount to the finance company. You might be charged an extra fee if your customer withholds payment longer than the advance term (in this case, 60 days).

Contract financing is useful when the credit history of a small or medium company is scant or poor, which can block access to conventional bank loans and commercial lines of credit. A contract financing company might approve a financing arrangement with you if the following applies:

  • Your customer has a good credit rating.
  • You have a signed contract with a clear schedule of milestones and payments.
  • You have enough of a track record to reassure the finance company that you can perform the work on time and complete each milestone properly.

Contract Financing Rates and Terms

The following table summarizes the average values of the terms found in contract financing agreements:

FeaturesAverage Terms
Advance amountUp to $5 million
Factor fee1.25% to 2.50%
Advance percentage80% to 90%
Advance term30 to 90 days

How to Qualify for Contract Financing

Each contract financing firm sets its own qualification standards, but, generally, they evaluate:

  • Time in business: A contract financing firm wants to see evidence that you can fulfill your contractual obligations. The longer you’ve been in business, the safer you’ll seem to the financing firm. However, being in business for a long time will not be all that helpful if your company has a history of lawsuits and defaults.
  • Monthly billing: The amount you want to finance should bear some relationship to your average monthly billing. A financing firm might want your monthly revenues to at least equal the amount necessary to cover the advance. For example, if you are advanced $20,000 for a 60-day term, the financing firm might want your monthly billing to equal $10,000 or more. The finance firm might have a minimum billing amount (often $5,000), and can set a cap on the amount it will advance based upon your billing history.
  • Credit rating of customer: The finance company advances up to 90% of the invoice amount. Therefore, it wants your customer to be creditworthy enough to pay its bills within the advance time period.

Where to Get Contract Financing

Contract financing companies are usually private firms, such as Abington Emerson Capital, Street Shares and Interstate Capital. You can find them online, but you won’t receive a lot of information from their websites. The general procedure is to leave your contact information and wait for a phone call from the finance company. Banks typically are not involved in contract financing. They are in the business of lending, whereas contract financing is a form of factoring, not a loan.

Businesses that are considering contract financing may also want to consider invoice factoring and accounts receivable factoring. These factoring methods involve the selling of your accounts receivable or completed invoices to a financing firm, also called a factor, that pays you a discounted amount below the face value of your accounts. Depending on the terms, you might receive additional funds once the customer pays the bill. These methods usually pertain to finished projects or events, whereas contract financing advances money based on interim progress toward the completion of a contract. Factoring firms can be found online. You can also find peer-to-peer factoring websites as well.

Justin is a Sr. Research Analyst at ValuePenguin, focusing on small business lending. He was a corporate strategy associate at IBM.