Five Questions to Ask When Considering Contract Financing
Contract Financing is an alternative form of financing that allows companies to access working capital by using the proceeds from an in-progress or upcoming project as collateral for a loan. Contract financing loans are underwritten based on the characteristics and value of the contract that the business is borrowing against, rather than the companies credit history. This enables new companies that have not established credit, or companies with impaired credit to obtain commercial financing. Contract Financing can be an important liquidity tool for new or rapidly growing companies that are unable to obtain traditional commercial financing.
There are many small and midsize companies that can benefit from contract financing. Understanding when a company should utilize this unique liquidity and financing tool can make a significant difference in the growth, profitability and long-term value of the company.
Here are five key questions a business owner should ask in determining if contract financing may be a good option for their business.
- Does the company have a signed/guaranteed contract from a known and reliable customer?
A confirmed contract is the first necessary element of a contract-financing loan. A lender will want to see that the contract is with a customer that the company has done business with previously and that the company successfully completed and was paid for similar projects or orders from the customer.
- Is the company experienced in the field and does it have a successful track record of delivering for its customers?
Because a contract-financing loan is secured by the successful completion of a project or order, a business’s track record in delivering on similar contracts is very important. A contract financing lender will review previous similar transactions to assess the likelihood that the current contract will be completed and paid. Factors such as the company’s years of experience in the field, competition, market conditions and considerations may also be assessed.
- Does the new contract require significant capital up front and place liquidity demands on the company?
Understanding why the company is experiencing liquidity demands and needs capital is an important element in determining whether or not a contract-financing loan is a good option. If the need for capital is a direct result of the liquidity needed to meet a large order and complete a large project, then project financing may be a good option. If the capital needs are not a direct result of the new project or order, but are attributable to other underlying demands of the business, then contract financing might not be the best solution.
- Is there a defined period by when you need to finish the project or deliver the goods and when the contract will be paid?
A defined time period in which the project or order will be completed enables the contract-financing lender to assess the risk of the loan and to underwrite it appropriately. While a shorter period of time is generally better, the terms and conditions of a contract-financing loan will vary. An opened-ended project is typically not a good candidate for contract financing.
- Is the contract profitable with margins in excess of 20 percent?
A company’s anticipated profit margin on the contract is the final consideration. Lenders will want to see that the company is making a reasonable profit on the contract with all of the financing costs considered. While different lenders will approach each loan from a unique perspective, generally a minimum profit margin of approximately 20 percent is necessary to make a contract viable for financing.
These are just a few of the factors to consider when assessing whether or not contract financing is the appropriate tool to meet a company’s liquidity needs.