If your construction business needs cash, but is looking for an alternative to a bank loan or credit cards, invoice factoring could be a viable solution. As with any financing arrangement, it’s important to understand the cost of factoring and its components. In this article, we’ll give you a breakdown of the costs of factoring an invoice, and how those costs are calculated.
Why contractors use factoring
There are a number of reasons why a contractor would consider factoring over other methods of construction finance.
When a construction project is first starting, subcontractors have to wait quite a while before their first payment comes in. If they submit the first invoice after 30 days, they won’t get paid until the GC, architect, and owner review and approve their application. That could take weeks. In the meantime, they still have project expenses to meet.
The delay between invoicing and getting paid can be difficult for companies without sufficient cash reserves. Invoice factoring can help construction companies cover expenses on a project before the GC or property owner actually pays their invoice.
Invoice factoring is a process in which a contractor sells an invoice or group of invoices to the “factor,” or factoring company. The factoring company pays the subcontractor a percentage of the invoice value immediately. They pay the rest – after subtracting the “discount,” or factoring rate – after they receive the payment from your customer.
Main components of invoice factoring in construction
The invoice
As soon as you submit a construction invoice or pay application to the contractor or owner for work you have already done, you should be able to factor it. You cannot factor future invoices, or invoices that are overdue. An invoice can only be factored for work already completed, before the invoice is due.
Retainage
Typically, factoring companies will subtract the retainage amount from the invoice before factoring it. As a result, they will only factor the net invoice, without retainage. In a practical sense, they consider retainage to be an extra progress payment at the end of a project.
Because retainage is so unique to the construction industry, you won’t hear factoring companies talk about this often. However, it’s important for construction companies to understand when considering factoring as an option for cash flow.
The advance rate
The advance rate is the percentage of the invoice that the factor provides up front. Some advance rates can reach as high as 98%, but they typically range from 80% to 95%.
Again, for the construction industry, the factoring advance rate would be calculated on the net invoice, with retainage subtracted.
The factoring rate
Also called the discount or discount rate, the factoring rate is the direct cost you pay for factoring an invoice. It is typically a small percentage of the invoice total. The factoring rate is typically calculated on a 30-day basis. The longer it takes your customer to pay, the higher this cost will be.
Once your customer pays the invoice, the factor will give you the remainder of the payment, minus the discount. How long a GC takes to pay an invoice also affects its factoring value.
The factoring rate often ranges from 1% to 5% of the total amount, and typically applies to each 30-day period.
Factoring rate options
Companies generally charge a factoring rate in one of two formats:
- Flat rate / flat discount
- Variable rate
Flat Rate
Using a flat rate, you pay the same percentage for each 30 days that it takes your customer to pay. If the flat rate is 1%, then you’ll pay 1% in the first month, 1% in the 2nd month, and so on.
Variable Rate
A variable factoring rate increases each month that the invoice goes uncollected. For example, it might be 1% in the first month, 2% in the 2nd month, and 3% in the 3rd month. The longer your customer delays payment, the more expensive it becomes.
Flat vs. Variable Rate: An Example
For simplicity sake, let’s say you factor a $100,000 invoice or pay application on a construction project, with an advance rate of 80%. You receive an advance payment of $80,000. The factoring company holds the remaining $20,000 in reserve.
Flat rate (1%)
If your customer pays after 20 days:
- The factor keeps $1,000
- You get $19,000
- Your total: $99,000
If your customer pays after 83 days:
- The factoring company keeps $3,000
- You get $17,000
- Your total: $97,000
Variable rate (1%, 2%, 3%)
If your customer pays after 20 days:
- The factor keeps $1,000
- You get $19,000
- Your total: $99,000
If your customer pays after 83 days:
- The factor keeps $6,000
- You get $14,000
- Your total: $94,000
Things that affect invoice factoring cost
The factoring rate or discount that you are charged will be influenced by a variety of elements. These include the amount you’re factoring, the advance rate, your customer’s credit, and so on. Each of these elements affects the risk that the factoring company is taking. Ultimately, the more risk the factoring company takes, the higher your factoring rate will be.
Customer credit
Before a factoring company buys an invoice, they will likely run a credit check on the contractor who hired you. Your invoice factoring rate can be affected by the creditworthiness of your customer. The creditworthiness of your customers will mainly determine whether or not an invoice will be funded.
Volume of invoices
The more invoices you sell to the factoring company, the better factoring rate you are typically able to negotiate. There are two common types of factoring based on volume: Spot factoring and contract factoring.
Spot factoring is when the contractor factors a specific invoice. Because spot factoring is considered risky, it typically comes with a higher factoring rate and lower advance rate.
Contract factoring covers all of the invoices or pay applications submitted over the course of a construction contract. Under contract factoring, cash gets provided in exchange for every progress payment. This is considered less risky than spot factoring, since it is more predictable. As a result, you can usually get a lower factoring rate and higher advance rate.
Learn more: The difference between spot factoring and contract factoring in construction.
Volume of customers
The number of customers that you plan to finance will also affect your factoring rate. Factoring companies are more likely to work with contractors that have a large book of business under their belt.
When you factor every invoice you submit to customers, the factoring company effectively takes over your entire accounts receivable department. Each invoice carries low risk when considered against all of the invoices overall. As a result, this method will usually give you the lowest factoring rate and highest advance rate.
Advance rate
The higher the advance rate, the higher the factoring rate is likely to be. The more cash you receive up front, the more risk the factoring company is taking. And you’ll pay for that risk with a higher factoring rate.
Your average collection period (DSO)
DSO (days sales outstanding) is a measure of how long it takes you to get paid for your receivables. The average DSO in the construction industry is 83 days. The higher your DSO is, the riskier it is for the factoring company. And the more they’ll want to charge you as a factoring rate.
Additional fees & factoring costs
Factoring companies will often charge additional fees, and they vary widely. They often charge application fees, setup and administrative fees, credit check fees, and more. They may be on-time fees or recurring fees, and are charged in addition to the factoring rate.
Recourse vs. Non-recourse
Some factoring companies will offer you the option of recourse or non-recourse factoring. In general, recourse factoring is much more common.
With recourse factoring, you will typically be required to buy the invoice back if your customer doesn’t pay after 90 days. You are responsible for collections, and any debt incurred. This is obviously less risky for the factoring company, so there shouldn’t be an extra charge for it.
If you choose non-recourse factoring, the factoring company assumes most of the risk of non-payment. If they aren’t able to collect payments from your customer, then it’s their debt. Because this assigns much higher risk to the factoring company, they charge an extra fee.
Video: Is invoice factoring right for your construction business?
Is invoice factoring worth the cost?
Factoring doesn’t come without a cost. Depending on your situation and the volume of invoices or customers the factoring company will handle, that cost can grow quickly.
However, factoring can bring real benefits to contractors in certain scenarios. If your customers reliably pay on time, and you need cash to cover expenses while you wait, it can be a cost-effective option. While it’s typically more expensive than a bank loan or line of credit, it’s generally much more affordable than using credit cards.
In addition, because the factoring rate is tied to a specific invoice, it can fit neatly into a contractor’s established job costing process. In fact, if you know that you will be factoring an invoice or contract in advance, you can build the factoring fees into your estimate.
Ultimately, factoring an invoice or contract can provide much-needed cash flow to contractors when they need it. And because, unlike conventional financing or loans, your credit and financial history isn’t a consideration, it’s a highly attractive option to small and medium-sized construction businesses.