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Is factoring the right move to help finance a construction project?

Sep 15, 2020
Construction Dive

Having enough cash on hand to pay the bills and fund new projects is always top of mind for contractors, especially labor- and material-heavy subcontractors that fund most of the activity on a construction project often months before the owner and general contractor pay their invoices.

Last October, construction finance platform Rabbet found that late payments cost general contractors and subcontractors about $64 billion a year, up $24 billion from a similar study Rabbet conducted the previous year.

More than 60% of contractors surveyed told Rabbet that they would not bid on projects if the general contractor was infamous for paying bills late, and only 39% said they had the available cash to cover operations until they were paid. The rest choose to take on the extra cost of various means of financing like credit cards or lines of credit.

The pain of having to scrape by until payday is so great for subcontractors that more than 70% said they would discount their invoices by 1% to 5% if it meant their invoices would see a quicker turnaround. That would create as much as $44 billion in project savings, according to Rabbet.

Add the COVID-19 pandemic into the mix, and cash-strapped contractors might be feeling the same type of pinch. Some say they are exploring as many ways as possible to get through to the next project.

The options for contractors that can’t secure traditional financing are limited, and this is where factoring enters the picture. Factoring is the term for when a contractor sells its invoices at a discount to a third party. This provides quick cash for the firm during the gap between when a contractor submits its invoice to a customer and when the customer pays the contractor.

In the early days of construction industry factoring decades ago, some operations were very aggressive, eager to make money by lending cash without being subject to the ever-expanding universe of bank regulations, said attorney Thomas Barber with law firm Munsch Hardt Kopf & Harr P.C. in Houston.

The typical factor scenario for subs, said Frank Skelly, managing director of FK Construction Funding, might see a subcontractor submit its pay application to both the general contractor and the factor. The factor would then verify the bill with the general contractor and then advance to the subcontractor the agreed-upon portion of the funds.

Of course, without enough oversight, Skelly said, the factor runs the risk that the general contractor is going to backcharge the subcontractor and not pay the bill in full. Or the subcontractor might not have been paying its suppliers and sub-subcontractors, and the general contractor has to withhold all or a portion of the subcontractor’s payment in order to remove mechanics liens or solve some other financial dispute.

There are many scenarios that could result in the factor not getting its money post-approval if there is not a holistic approach to the factoring relationship, he said.

“Factoring without funds control is like driving a race car without a seatbelt,” Skelly said. “It’s insanity.”

The factoring companies take a fee starting at about 5%, Barber said, and then for every 10 days, for example, that the contractor went beyond the factoring commitment in terms of collection of the purchased invoice, the rate would increase possibly to 10%.

“Not many operations can sustain borrowing money at 10% a month and remain in business,” he said.

Other fees would appear as well to eat up the difference between what the factoring company advances on the invoice — usually about 85% — and any money the contractor still had coming after collection of the invoice.

Key benefits of factoring

Why would contractors agree to such terms?

Working capital and capacity go hand in hand, said Bill Fischer, partner at accounting and consulting firm Grassi, and contractors could exhaust or not qualify for more traditional means. A growing company, even one that has profitable projects, he said, might not be able to pay down a line of credit, for example, when it is always investing its cash into new projects.

But the good news is that the factoring industry has become “kinder and gentler” over the years, Barber said, with interest rates coming down and major banks getting into that market.

“Now that there’s competition … it’s not unusual to see a rate as low as 2% or 2.5%,” he said. “And the times for collection have extended a bit to 20 to 30 days.”

In fact, some factoring companies, like FK, have added value to their financing services, becoming as much of a partner as a lender.

Instead of writing a check and hoping for the best, FK manages the financial aspects of the project, ensuring that vendor, supplier, payroll and tax obligations incurred on the project are resolved before the subcontractor gets any excess funds.

“We don’t call it factoring,” Skelly said, “because it’s a very small component of what we do.”

On every project FK accepts — there is a screening process that rules out jobs that are likely to be under water — the company lets the general contractor, suppliers and vendors know how much of the client’s contract amount has been allocated to them.

Not every general contractor is on board at first, he said, because there is a fear sometimes that factoring can affect the contract agreement or that the factor will be a nuisance. Now, the company focuses on selling the concept of funds control to owners and general contractors in an attempt to get them to refer their subcontractors.

The perception of the company has evolved to the point that some general contractors have waived bonding requirements for subcontractors that participate in FK’s programs, Skelly said.

For those general contractors that still want to protect themselves, Barber said, they should:

  • Keep lines of communications open with the subcontractor and verify they have a valid agreement with the factor.
  • Notify the factor that the invoices are subject to the terms and conditions of the subcontract and that payment will be withheld if the subcontractor does not perform.
  • Send notice to the factor that payment remitted to addresses outside of the jurisdiction listed in the subcontract does not constitute consent to change the jurisdiction.
  • Notify the factor that the right to rescind or stop payment if the subcontractor is terminated or declared in default – and potentially also to offset payments to the subcontractor if they are in default on another project – is still in effect.

“I set all of these things out in a form letter, and I advise my clients, before they make any payments under the factoring arrangement that they’ve got to have that form letter signed and acknowledged by the factor,” Barber said.

Even under the best situation, Barber said, on an annualized basis, the lower interest rates that some factors offer can work out to be very high. Contractors, he said, might want to consider alternatives before they make the leap to factoring, like asking the customer for early or accelerated payments for a discounted rate.

"If you're going to take on an enormous amount of work, and you don't have the working capital to do that, then you better be very smart with the customer that you choose to work for and make sure those customers understand, 'I need to be paid on a regular basis every 30 days,’” Fischer said. “No questions.”

At the end of the day, Skelly said, factoring is a tool, just like any other, and it has to be the right tool in order to get everyone paid.

“If you use it to get yourself out of debt or to bring money forward to [pay previous bills] … then, no, it’s not the right tool,” he said. “[When used] specifically to finance projects, we keep these jobs out of trouble.”

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