There are more and more lenders entering the market of constrction factoring. This should be good news for construction companies and it may well be, however, there are some real potential pitfalls for companies that use this form of finance.
For many construction contractors this form of finance may present a real lifeline and an opportunity to finance growth but it is imperative that you understand how it works and how charges can mount.
One frustration I have is that businesses who are on the fringe of the construction industry can be assisted by more traditional factoring providers. Unfortunately lenders with specialist construction factoring products will ‘force’ these businesses down this route as it reduces their risk, reduces their exposure, increases their fees and ultimately provides a better return for their shareholders. There seems to be little benefit for the business that is ‘forced’ down this route.
Construction factoring is designed to help businesses that raise applications for payment on stage payments against contracts that are typically with main contractors. These type of business are hard to finance because of the risks involved in collecting in outstanding sums when a business fails. By the nature of these businesses, what they are doing and the contracts they are fulfilling the work is likely to be part finished if they fail and the main contractors will need to find another supplier to complete the work. They have the right to implement ‘liquidated damages’ clauses if they are within the contract and as such rarely pay. For this reason the whole focus of construction factoring companies differs to that of more traditional invoice factoring providers. While a traditional invoice factoring company will want to ensure that invoices will still be settled in the event of business failure so they can recover their debt a construction factoring company will want to ensure they have recovered their exposure before any business fails.
So what should you be aware of?
Pricing: the cost of construction factoring is considerably higher than traditional factoring. This is because the risk is typically higher, the workload is higher because of the way they monitor contracts and also because the market of providers is somewhat limited. The market is growing due to the ‘super profits’ that have been achieved by specialist construction factoring providers.
Additional fees: some lenders are renowned for charging additional fees and it is fair to say that the construction factoring providers fall within this category. These additional fees can be hard to predict and can be significant. They can range from reviews and surveys by their chosen QS to penalties for not meeting their cumbersome administration requirements.
Prepayment: this is typically much lower than with traditional factoring facilities which offer up to 90% prepayment. Construction factoring typically offers between 20-60% depending on what type of work you are undertaking.
What is actually funded? While prepayments are lower than what is traditionally offered the restrictions can be higher meaning that even less funding is generated. Final accounts are not funded and what constitutes a final account is open for negotiation. However, it can be considered by construction factoring companies that the last 25% of the contract is open to being the final account. One provider definitely takes this approach and as such the funding is only available against 75% of the contract value. Some contracts can become inelligible for funding altogether. If the cash paid against applications drops below 90% of what has been applied for on a contract that contract will no longer receive funding.
Administration of the facility: this can be cumbersome. You need to provide monthly or quarterly management accounts by an agreed date. You also need to provide bank statements on a weekly basis. If these are not supplied on time you can receive financial penalties and further reductions in funding. Contracts will be reviewed by the lenders QS and you will be expected to follow the contract to the letter irrespective of how you normally operate.
We have set up several construction factoring agreements on behalf of clients where it is necessary and suitable. However, we have also found more traditional factoring facilities for clients that were being told they had to use a construction factoring product. A more traditional factoring product will typically have a higher prepayment, less administration, and lower fees meaning it is a better option.
If you do need to use a construction factoring facility it is important you fully understand how it works. You need to be sure you can meet the administation requirements and that the costs make it viable for your business. You also need to understand how cash is generated and what restrictions can be imposed so that you can forecast accordingly.
