Factoring Can Help Improve a Subcontractor's Cash Flow

When your banker says "no" and you've fallen below the radar screen, an alternative financing company who thinks outside the box will often say "yes."

By Howard Chernin

In the construction business, one of the worst things that can happen is for a project to stop in its tracks. This results in delays, higher costs and very dissatisfied customers.

Borrowing from banks is one possible solution for contractors and subcontractors, but this option has severe restrictions.

The most obvious problem is that banks generally insist on securing assets equal to a minimum of three times the amount of the loan. Another is that a borrower can not secure additional funds without renegotiating the loan — or even starting the process all over again with a different lender.

A third is that a borrower is required to meet monthly payment obligations, which may be difficult or even impossible. Then there's the fact that banks are often reluctant to help finance contractors and subcontractors. In short, borrowing from banks limits flexibility so severely that it is rarely a realistic option.

Given these realities, the need for alternative methods of financing construction deals is tremendous. Factoring is quickly becoming the alternative financing method of choice in the construction industry. An experienced factor can help a contractor or subcontractor survive financial setbacks and bankruptcies quickly and simply by financing their receivables.

Factors are also valuable resources to contractors and subcontractors because they can help improve cash flow to pay suppliers, payroll, and taxes. This enables construction companies to purchase supplies and equipment and increase their labor force to keep businesses afloat in times of economic difficulty.

There are numerous advantages. With factoring, a contractor or subcontractor does not have to borrow money, makes no monthly payments, and can exercise control over how much is factored and how often. Perhaps most important is the fact that the money can be available in as little as 24 hours.

One recent example of how effectively factoring can work involved a California carpenter working on a large residential development. The carpenter was able to increase his cash flow, which in turn allowed him to buy supplies, pay his laborers, and purchase the equipment necessary to finish what has turned out to be his largest job ever. Without the help of factoring, the carpenter would have been forced to limit the size and scope of his projects — and forgo the opportunity to grow.

Another example involved a subcontractor in the Midwest working on a large commercial development project who desperately needed an infusion of cash. It was determined that the subcontractor would be able to receive an advance, under a no-term contract and with no-credit risk, equivalent to 60 percent of a single invoice totaling $100,000, or a sum of $60,000 that would be wired directly to his bank account.

The subcontractor agreed to pay four percent fee for the first 30 days. In other words, he would pay $4,000 to factor a $100,000 invoice for one month. He would receive the balance of the money $36,000 — or $40,000 minus the $4,000 fee — upon receipt of the funds due toward payment of the invoice. He therefore received $60,000 plus $36,000, or a total of $96,000 for his $100,000 invoice.

Because this particular subcontractor had no experience with factoring, he was reluctant at first. Yet he realized that he was operating in an extremely competitive market. Further analysis of his financial situation revealed that his gross margin was 18 percent and that his annual overhead was $150,000. The subcontractor commented that if he had access to "unlimited funds," he could double his business from $2 million in annual sales to $4 million. He admitted that he was turning away business because he simply did not have the cash flow to handle it.

For businesses involved in construction, factoring can be the ideal way to stay in the race — or to grow dramatically. Factors do not buy retention, meaning monies are withheld by the owner until a project meets the owner's satisfaction. What they do is supply cash — cash that can help contractors and subcontractors meet their payroll, tax, and insurance needs, pay their suppliers, and receive greater discounts from them.

Howard Chernin is senior vice president of Quantum Corporate Funding, Ltd in New York, N.Y.

To submit a "Bottom Line" article — any topic that pertains to the business of design and construction — contact the editor at heather_hatfield@mcgraw-hill.com)