What’s the Best Method of Government Contract Financing for You?

Government contract financing is, all too often,the next subject that businesses worry about after they have won a big contract. Small and mid-sized businesses, in particular, finish celebrating victory by wondering how they will pay for the supplies, equipment or employees they suddenly require

Businesses that don’t have the capital to ramp up for a new contract need ways to secure it. They also can find themselves short of cash in the middle of a project, because they must cover expenses up front, deliver the products or services, and then wait for the government to pay. The federal government, the biggest buyer of them all, pays its bills, but does so according to its own ponderous schedule. It generally takes 30 to 60 days. Businesses don’t get that kind of leeway from their suppliers, and they certainly can’t pay employees every 30 to 60 days. 

Many companies profit by this predicament and their ability to supply government contractors with money when it’s needed. They provide a wide range of government contract financing options. The contractors need to choose carefully, however, to make sure they pick one that doesn’t eat up too much of their profit. This article will review several common types of government contract financing. In each case, it’s important to know the full potential cost of the financing, including all possible fees, before making a decision. 

Will banks finance government contracts? 

Banks will happily loan money to government contractors who have an excellent credit history and a strong business record, especially if they have collateral too. Banks also like to work with businesses they have a relationship with. This type of company can usually find lower rates and fees at a bank than anywhere else, and the bank is likely to lend them the most money for the longest period of time.  

However, companies that do not have that type of record, like small businesses working on their first government contract, might not get a bank’s best terms. Also, banks might not move quickly enough to suit the needs of contractors. 

Can I use a line of credit for a government contract? 

A line of credit is an excellent tool for businesses. They can get approved to borrow up to a certain amount – $5 million or more depending on the lender and the company’s revenue. They can access the money as they need it during the term of the loan, borrow only what they need, and pay interest only on that amount. Borrowers can get a secured line of credit using assets such as billed invoices, work in progress and delivery orders. Lenders give better rates and terms on secured lines of credit than on unsecured loans.   

The flexibility comes at a price, however. Without an excellent credit rating, the interest rate can be quite high. Rates might be variable, too, so costs could rise unexpectedly. Lenders might charge origination fees, annual fees and even fees when the credit line is not being tapped. They also might require weekly payments. 

Factoring and government contracts 

Factoring differs from a loan in that the factoring company, or factor, takes possession of an asset rather than accepting it as collateral. 

Invoice factoring 

Invoice factoring, for example, is a common way to finance government contracts. The federal Assignment of Claims Act made it possible for government contractors to assign moneys due or to become due under a contract to another party. 

Here’s how it works: Small Business X has a $100,000 invoice for work on a government contract. Instead of submitting it to the federal government, SBX sells it to a factoring company. That company subtracts a 2% factoring fee, or $2,000, from the invoice value. Within a couple of days, SBX receives 90% of that new value, or $88,200, from the factoring company. That’s much faster than waiting 30 to 60 days for payment.  

The factor owns the invoice and deals with the vendor to get payment. The vendor pays in full in 30 days and the factor sends the remaining amount, $9,800, to SBX. 

Factors set their fees according to several criteria, including the credit history of the company paying the invoice, not the contractor. By choosing factoring over a loan, SBX avoided taking on new debt and debt payments, and the deal will have no effect on its credit rating. 

Factors also consider whether the deal is “recourse” or “nonrecourse.” In a recourse deal, if the vendor doesn’t pay, SBX would have to buy back the unpaid receivable or replace it with a more current receivable. (The longer invoices go unpaid, the less likely they are to be paid.) In a nonrecourse deal, SBX can’t be touched if the vendor doesn’t pay. Of course, the factor fee is higher for nonresource deals. 

Factoring companies also consider the volume and size of invoices, the industry, and the length of time it takes customers to pay. Those factors help to determine the factor fee and the percentage of the invoice paid in advance to the contractor. Contractors also need to be aware of hidden fees, like application fees, credit check fees, fees for late payments by vendors, and processing fees. 

Non-notification factoring 

One of the drawbacks to factoring is that a contractor puts its relationship with a vendor at risk when it turns over collection to a factor. What if our example company, SBX, preferred to not let its vendors know that it used factoring to help with cash flow problems? If could use non-notification factoring, which means that communication between the factor and the vendors would be done only in SBX’s name and with its letterhead. Factors charge extra for this service, however. 

Purchase order factoring 

This is similar to invoice factoring, but applies to purchase orders. What if SBX won a $200,000 contract to supply some government agencies with staplers? SBX can find a supplier who will ship the staplers for $150,000, but it doesn’t have that much money at hand. SBX’s purchase order with the supplier is a contract that must be paid. Based on that, a factoring company can structure a deal that allows SBX to fulfill its contract and make a profit. Sometimes the arrangement will include both factoring and lending.  

This is a viable option for government contractors who have a high profit margin to work with and who are resellers or distributors, and not manufacturers.  

Asset-based financing for government contractors 

Companies can obtain term loans or revolving lines of credits by securing them with assets like invoices, equipment, inventory, and property. They might even use a combination of assets as collateral. 

Businesses that can’t work with traditional lenders can use asset-based financing to solve cash flow problems. Asset-based financing generally comes with few strings attached. A government contractor can use it for any business purpose. Another plus: The costs tend to be lower than factoring. 

On the negative side of the ledger, assets must be of significant value, have a high appreciation rate or have a low depreciation rate to qualify as collateral. Inventory, in particular, can be downgraded and not provide as much collateral as a company might expect. Also, lenders must spend time assessing the collateral, and the costs of underwriting are higher than with more-traditional loans, so the costs to borrowers is higher. The biggest downside for borrowers, however, is the risk of losing assets if they default on the loan. 

Mobilization funding 

Mobilization funding is popular in the construction industry, which has to invest heavily in projects immediately and long before it begins to get paid. Companies that must buy materials, buy or rent equipment, move the equipment and set it up on site, and beef up the payroll to get a project started are the prime target for mobilization funding. 

This method, like purchase order factoring, uses a combination of factoring and lending to help companies with cash flow. A finance company advances 10% to 20% of a project’s cost to the builder. Based on the schedule of expected payments to be made by the client, the finance company sets up a cash flow schedule. The arrangement puts the contractor at ease because it will have funds to cover its expenses throughout the project. And it can repay the finance company as payments come in from the client.  

Government contract financing through the SBA 

The Small Business Administration offers many services to government contractors. The SBA works with federal agencies to help see that 23% of prime government contract dollars go to small businesses. It also backs loans that have favorable rates, with the 7(a) program being the most popular with government contractors. That program loans up to $5 million that can be used for working capital, refinancing debt and buying furniture, fixtures and supplies.  

The SBA’s CAPLines program offers loans that can be useful to government contractors as well. A Contract CAPlines loan, for example, can be for as much as $5 million. The loan is designed to provide short-term financing for performance of a contract, sub contract, or purchase order, and can be repaid when the business has been paid by its customer. (In other words, the federal government is backing a loan that will be repaid when the contractor receives money from another part of the federal government.) 

The SBA promises lenders that it will repay up to 85% of any loss in case of default. A business applies for a loan with a bank, but the SBA sets standards for the conditions, qualifications and terms of the loans and reviews applications.  

The CAPLines’ Working Capital Line of Credit program – also for up to $5 million and as long as 10 years – is for short-term working capital and operating needs. 

Look before you leap 

Government contractors must think ahead when they bid on a contract. It can take weeks or months to set up the necessary financing, so it’s a good idea to start early. It will make celebrating the award of that big contract much more enjoyable.  

Looking further still into the future, eventually every business owner exits from his company. GovCon Wealth, a division of Cope Corrales, exclusively focuses on advising successful government contractors, and aligning their company, personal and financial objectives.

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