Invoice Factoring in the construction industry, for both general contractors and subcontractors, is a financial solution where a business sells its accounts receivable (invoices) to a third-party factoring company in exchange for immediate cash. This process helps improve cash flow by providing capital without the need for traditional loans. This is especially beneficial when dealing with long payment terms common in construction projects.
The factoring of construction related receivables is certainly one of the more difficult niche areas of factoring from the transactional standpoint. The need for financing in this segment is so great that many industry brokers and commercial finance consultants can actually focus 100% of their marketing efforts on construction factoring for general contractors and sub-contractors alike. While many factors and lenders shy away from this industry, we have become experts in all aspects of this important niche area and welcome clients from all areas of construction and engineering.
Why is Construction Receivables So Difficult to Factor?
First, you need to know that construction factoring provides services to several different categories of prospective clients. And when factors finance in this sector, one size does not fit all. From a product knowledge standpoint, there is quite a bit for commercial finance consultants to learn.
In the construction sector, we will have three possible types of clients or prospect groups for financing. They are:
- SUB-CONTRACTORS: Those actually performing the work on a job site and being paid for that work by a General Contractor
- GENERAL CONTRACTORS: Seeking to get advances on progress payments made to them by project owners or banks
- SUPPLIERS: Businesses that supply materials to the job site. This is everything from lumber and trusses to bulk hardware.
Of the three groups, sub-contractors tend to be our largest market for financing and the easiest to actually interact with. The second most promising group will be suppliers. The general contractors themselves are the smallest group and by far the most difficult to finance.
Factoring Sub-Contractors
The factoring of sub-contractor receivables is the most common in this niche. Here, the invoices being factored are those payable by a general contractor to the sub-contractor for its work on the job. What makes this area difficult? Here are a few risks not typically associated with standard factoring:
- RETAINAGE: Most sub-contractor invoice payments are subject to something called retainage. Retainage (usually 10% of the invoice face amount) is a hold-back the general contractor retains for (sometimes up to a year) to offset poor craftsmanship that may show up well after the sub-contractor has left the job site. Because of retainage, all sub-contractor invoices factored are subject to having additional reserve held of 10%. A normal 80% initial advance becomes a 70% or even 65% advance.
- SETOFFS: General contractors most often enjoy something called rights to setoff. This means that an invoice payment for a current job performed may be reduced or “setoff” by a chargeback on a job performed months prior.
- VERIFICATION: While the verification process is usually very straightforward in most everyday factoring transaction, it can be problematic in construction. This is because the invoice verifier, in the normal chain of command in a construction deal, is the project manager who will typically be on the job site and difficult to access.
- CONDITIONAL LIEN RELEASE: Prior to paying an invoice, the general contractor will require a conditional mechanic’s lien release which protects it from the sub-contractor filing a lien against the job after being paid. This creates some additional paperwork for factors and it can also create a logistical problem since the general contractor will not pay without the release and the release must often be signed in person at the general contractor’s offices.
How Construction Factoring Works for Contractors and Subcontractors:
A general contractor or subcontractor submits their unpaid invoices (or payment applications for subcontractors) to a factoring company.
The factoring company purchases these invoices and provides an immediate cash advance, typically a percentage of the invoice’s value (e.g., up to 90% or 95%).
The factoring company then collects the full invoice amount from the end customer (the client of the contractor or subcontractor) when it becomes due.
Once the customer pays the factoring company, the factoring company deducts its fee and remits the remaining balance to the original business
Benefits for Construction Businesses:
Provides immediate access to working capital, enabling contractors and subcontractors to cover operational expenses, pay suppliers, and manage payroll without waiting for customer payments.
Frees businesses from the burden of chasing late payments and dealing with extended payment terms.
Factoring is not a loan; it’s the sale of assets (invoices), meaning it doesn’t add to debt on the balance sheet.
Offers a viable option for businesses that may not qualify for traditional bank loans or lines of credit.
Considerations and Limitations:
Factoring companies generally cannot finance invoices with “pay-when-paid” clauses, as the payment is contingent on the general contractor receiving payment from their customer.
While transparent, factoring involves a fee, which is deducted from the advance amount.
In some factoring arrangements (non-recourse), the factoring company assumes the payment risk if the end customer fails to pay.
While many factoring services cater to commercial projects, some may also fund residential subcontractors working for strong national builders