Most business owners give up when they fail to secure a traditional bank loan. More so when they can’t succeed with other funding options- investors, crowdfunding, PLO financing, name it! If you are stuck between the proverbial rock and a hard place, maybe it’s time to look elsewhere. Other business funding options can grant your working capital a lifeline. Two of the most essential are accounts receivable financing and contract financing.
While both can hand your business the kind of growth capital, scalability, and flexibility it needs, they are two very different financing options. Our experts at LQD Business Finance go the length to break down each one of them.
Accounts Receivable Financing (A/R Financing)
Accounts receivable financing is similar to a traditional loan concerning how it works. While a typical loan requires that you present tangible assets (such as property or even personal assets), accounts receivable financing places your firm’s account receivables as collateral. Simply put, it is a type of asset-based lending which helps to clear the unpaid invoices.
How it Works
This type of loan usually has strict qualifications. Your firm’s accounts receivable must meet the financier’s qualification requirements. Upon approval, you MUST advance 70%-95% of your invoices to the lender. They will also charge a holding fee of about 1%-5%, depending on the size of your invoice. The loan you receive will usually be the net percentage of financing charges.
Also, you will not need to sell off your accounts receivable (at least not entirely). In the period when your accounts receivable will be on hold, you will still be able to collect payments from clients. But your company will run seamlessly, just like before.
Let’s use a practical example to elaborate on this concept.
Your tech company isn’t doing as well as you anticipated. Let’s say you have outstanding invoice balances totaling $100,000, which you must clear to make payroll this month.
You would contact a lender (also called a factoring company) and have them draft an account receivable financing deal for you. Then they’ll fulfill a percentage of your invoices upfront. As mentioned, it can never be 100% because they’ll need to take a cut.
Going forward, you’ll have the cash to clear imminent payrolls, and the receivables financing company will assume responsibility to pay off those invoices. Isn’t that a big WIN for your struggling finances?
When it Works Best
- If you need a loan with ZERO physical collateral, which means no property. No personal assets. Nothing!
- If retaining the ownership of your business is a top priority.
- If you need to inject your working capital with fast cash
- If you need debt-free cash flow
Keep in mind that receivables financing is not a loan. So it may give your balance sheet a clean slate because you will not incur additional liabilities.
- If you need a simple loan application and underwriting process
- If an immediate cash influx can stimulate growth in your business
- If you are either a high credit-risk company or a startup
Unlike receivables financing, contract financing is a way for your firm to receive cash in advance for work you are yet to perform. A legal contract binds the agreement between you and your customer. The deal essentially stipulates the milestones and payments based on your overall progress in the project. Contract financing differs from a traditional loan (or most financing options) in that underwriting occurs with regards to:
- Terms of the contract
- The creditworthiness of your customer
- Track record that you can perform the work within schedule and complete each milestone accurately.
How it Works
Contract financing comes in diverse forms. Your business’ trading history and your professional reputation for delivery will impact how the lender regulates finances – payments and expenses notwithstanding. The more established your company is, the less requirement there is to control cash.
Contract finance advances most of an invoiced figure right way, with the balance- less a charge- paid to you at the time of fulfilling the invoice. If your company operates by contractually agreeing to produce parts or perform services for a specific project, then contract financing might just be the ideal fit. This arrangement your company to avoid waiting many weeks to, possibly, receive payments on invoices you advance directly to the customer.
For instance, suppose your firm manufactures durable goods, and a client hires you for a long-term project for $600,000. You sign a contract that outlines six milestones with precise deadlines and tasks. Each of them pays $100,000 upon successful completion. Since you know that this client takes two months (60 days) to pay upon receiving an invoice, you choose to contact a credit financing firm that charges a base fee of 2% for an advanced term of 60 days.
Once the financier endorses the arrangement, they will take over the project invoicing. All you have to do is forward the invoices upon completion of each milestone. In the example above, the lender advance is 90% of the invoice figure ($90,000). The money only changes hands when the submission pulls through. Then your lender forwards the invoice to your client and pays your company the balance ($10,000). The amount is less a factor fee (2% of 90,000= $1,800) when the client finally pays the invoice amount to the lender one month later. So you will end up receiving ($10,000-$1,800) $8,200.
When it Works Best
- If you secure a contract and in need of urgent funding to complete the project.
- If you want the company to thrive and take on bigger projects in the future
Contract financing gives your business the flexibility to handle multiple projects, plus you won’t have to redo the underwriting process.
- If your company doesn’t qualify for a conventional loan from a bank or any other financial institution
- If you need to streamline cash flow through the existing assets
- If you are looking for a low-cost solution compared to asset-based lending
Similarities between A/R Financing and Contract Financing
Many mid-level companies experience rapid growth, sometimes on a massive scale. At such a point, the orders outweigh the existing working capital. What follows is inadequate cash to fund the operational needs of the business or even handle new orders. Both contract financing and A/R financing can afford your business with a timely injection of capital to stabilize its production cycle and delivery.
Both of these loan options can provide cash in a matter of weeks (two months at most). They are suitable if your credit scores are wanting or inferior. B2G and B2C companies- manufacturing, retail, tech- are the most eligible for this kind of business funding.
Often, A/R financing and contract financing offer access to a large pool of working cash. The weight of your invoices and the creditworthiness of your client(s) will determine the amount of your credit line.
Differences between A/R Financing and Contract Financing
Although both of these funding options can serve the same purpose, they are fundamentally different. They are applicable under various financial loopholes. A few standout differences between them include:
Qualifying for receivables financing is way seamless than qualifying for contract financing. First off, you only deal with the lender, which means no third parties. Loan approval can take the shortest possible time, with no bottlenecks in between.
On the other hand, contract financing involves more parties- you, the financier, and your client. For approval to pull through, the lender must affirm the creditworthiness of your client. This means you have no say in the context. Loan eligibility depends on a lot more factors as opposed to when only two parties were involved.
On the flip side, regulation of finances can be a MAJOR deal breaker. There’s a high risk of becoming a passive dealer in a contract financing agreement. Moreover, your working capital can suffer a blow if either parties sue you or pull out. This may leave your company grasping at straws.
Unlike in contract financing, A/R financing doesn’t look into your reputation or delivery history. That means you have higher chances of getting a loan- and a big one too- if your invoices tick all the right boxes.
While we’ve delved into scenarios where A/R financing or Contract financing might work, it is not in any way an all-inclusive guide. You have to explore each of these financing options with a third-eye before putting pen to paper. Also, don’t forget to assess your lending situation, existing working capital, and the need for sustained growth when making a decision.
We strongly believe that accounts receivable financing can be an excellent option —the KEY reasons being its flexible loan structure, scalability, and zero leverage. Our cutting-edge loan solutions at LQD Financing can help you wade the murky waters, ensuring that you sustain business growth in always possible. We prioritize business success and robust relationships more than anything else. As a transformative leader, we strive to provide customize-able financing solutions. That includes a streamlined underwriting process and the best rates in the market (12%-19%).