When you hear the term “contractor,” you might be thinking of someone in the construction business. The reality is that if you sign a contract to deliver materials, perform a service, or provide labor, you are technically a contractor. The contracts you work to deliver are valuable assets you can turn into cash now, rather than waiting until you’ve completed the terms you’ve agreed to.
As a business owner, contracts have a long list of advantages. They offer legal protections, make accounting easier, help with communication, and provide timelines. But here’s one advantage to working with contracts you may not be aware of – factoring. If you’re not familiar with factoring, this article will break down the basics of how you can use factoring to access working capital so you can deliver on larger contracts.
What is Contract Factoring?
The cycle of delivering, invoicing, and then waiting for payment before bidding on the next contract stunts the growth of your business. Ideally, you want to expand your business so you’re able to take on larger and higher-paying jobs. That can’t happen when you don’t have the capital to invest in the labor and materials you need ahead of the new bids.
Contract factoring (very similar to accounts receivable factoring) is one way to boost working capital so you can hire, deliver on time, and grow. In essence, you can sell your existing contracts to a factoring company, or “factor.” The factor pays your company for the contract and takes over processing the payments from your client. The factor earns a commission on the payments that come in, and you get the rest.
Here’s a quick example:
Let’s say you own a company that processes wood into matchsticks. You have a contract with Millhouse’s Matches to deliver 10 tons of matchsticks to them each month in exchange for $100,000. But, you want to bid on a job for David’s Match Emporium to deliver 15 tons of matches for $200,000 and you need more wood. To buy that wood, you need extra capital and this is where the factor comes in.
Factor X agrees to buy your contract with Millhouse’s Matches for 90% at $90,000. You send notice to Millhouse’s Matches that future payments should go to the factor’s address. Now, you take that $90,000 to get the extra wood you need. When your client pays Factor X, they get their initial $90,000 back, subtract their commission, and give you the remainder.
The best part is, you now have the capacity to bring in the account from David’s Match Emporium. So, you’ve grown your business by accessing the cash to get more wood and fulfill the second contract. You’ll be producing 25 tons of matchsticks instead of 10 tons and making $300,000 monthly instead of $100,000. You can see how business can continue to grow from there.
How to Start Factoring
The most important first step is to contact a broker. Why use a broker? It’s simple. There are many factoring companies to choose from and they don’t all have the best terms for your business. Because brokers deal with factors daily, they can quickly identify with whom you might work best. They’ll often be able to present you with multiple options in terms of the deal. You don’t have to do as much legwork finding the right factor, and a good broker will help you estimate your costs as compared to other options to help you determine if it’s the right path for you.
Once you’ve worked with a broker to evaluate your costs (i.e. the price of wood and any additional expenses), you can move on to step 1. Please note that these are general guidelines to give you a starting point. Your broker or factor may have more specific recommendations and requirements.
Step 1: Cost of Capital
This first step is to evaluate your cost of capital. There are varying definitions for “cost of capital.” Regarding factoring, cost of capital is how much it will cost you to factor your contracts. How much will it cost you to factor for one year versus three years? What commissions and fees does the factor charge?
Step 2: Financing Options
Factoring isn’t the only way to get extra working capital for your business. Before you decide to take the factoring route, you should weigh it carefully against the other available options. Lines of credit, short-term loans, SBA loans, and hard money loans are all options for most businesses. In some cases, they could cost you less than factoring.
Step 3: Budget
The next step is to develop your budget, including your cost of capital. Factoring brings in cash, but it also costs money. Even if you need that extra working capital no financing option will help you in the long run if you can’t afford it. It’s worth taking the time to have a realistic look at your company’s finances.
Step 4: Bid with Confidence
Once you’ve evaluated your finances and decided that factoring is the right choice for you, it’s time to put it to work. With a reliable cash flow to back up your bid, you’ll have the confidence to know there won’t be any trouble holding up your end of the deal. You’ll also have supporting documentation that shows you’re ready to take on the work.
Step 5: Retain Capital
It might seem like choosing a factor so you can win the bid is where your relationship with your broker ends, but that’s not true. As long as you continue to grow your business, a reliable broker can be a valuable part of your team. As you advance, your financial needs will change. Work with your broker to retain the right amount of working capital as you grow.
Contract factoring can give you the boost you need to break out of your current cycle and expand. You have several choices to make when you look at factoring. Brokers are in an ideal position to provide the knowledge and experience you don’t have the time or desire to build yourself. They can help the factoring process flow smoothly, so you can have the funds you need faster. Get started by contacting our office today!