Financing Options for a Construction Business – What You Need to Know
Cash flow is a constant challenge faced by small businesses, no matter the industry. Construction businesses, in particular, can be vulnerable to cash flow and funding challenges given the nature of the business. Substantial upfront costs and payment cycles are commonplace in construction. Combined, it makes the construction industry a particularly difficult one to obtain financing in, especially for small businesses.
Some lenders may not understand or care about what makes the construction industry-unique as compared with other industries that don’t face the same challenges. These funders who know little about the unique financial challenges for construction businesses may insist on giving out conventional financing terms even if the financing extended on those terms does nothing for the borrower. However, there are options available for construction businesses to obtain much-needed funding even if they haven’t received approvals by a bank or financial institution for a conventional bank loan or other forms of financing.
The Nature of Cash Flow In the Construction Industry
Construction is an industry in which it is virtually impossible to run a small business without obtaining a loan or financing of any kind at specific points in the construction process. It’s true regardless of whether your small business is a general contractor, a subcontractor, or other construction-related company.
Construction projects often have an enormous upfront cost for materials, supplies, labor, permitting, and additional fees associated with every construction project. That is particularly true for general contractors, who are laying out substantial sums to break ground on a construction project.
Subcontractors are often responsible for the same or similar types of upfront costs that general contractors are. Employees need to be compensated regularly regardless of what stage the project is at or whether the contractor or subcontractor has gotten paid. Equipment and supplies have to get leased or purchased irrespective of where things are in the construction project life-cycle.
To make matters worse for small construction business owners, customers in the construction industry often make payments per a set of predetermined milestones on the progress of the construction project. That is commonly known as the draw schedule. Which means, a part of the contract price gets paid when the contract is first signed, while subsequent payments are dispersed after construction is at a particular stage of completion. The final payment isn’t made until the project has been completed and delivered. This hurts construction businesses with regular expenses that may not coincide with the payment schedule of a particular project.
Payment frequency is particularly challenging for small construction businesses, regardless of whether you act as a general contractor or subcontractor on construction jobs. Construction company owners face the same central problem; Cash-flow from payments on a project may be inconsistent with on-going costs to finish construction. Often the result is a need for the construction business to secure financing to secure itself over through the entire project.
Financing Options for Construction Businesses
Construction financing often can take several different forms depending on the particular nature of the financing needed as well as whether it is for a specific project or instead for general working capital. Each of these financing options carries different repayment terms, interest rates, amounts a borrower can obtain, and cannot necessarily all get used for the same purposes.
Bank loans are what most people think of when they think about loans or financing. The borrower goes to a bank, meets with a loan officer, fills out some paperwork, and the loan application is then approved, with repayment to start sometime in the future. This type of financing involves a bank validating a borrower’s request for a certain amount of funding for a specific project with a set payment schedule.
Bank loans often are paid back over a more extended time than some of the other contractor/construction financing options. These loans typically carry a fixed interest rate, and repayments will generally be a fixed amount at certain regular intervals, most often monthly. However, it can be challenging to get approved for a business bank loan as a small business in the construction industry. Many banks and other financial institutions shy away from making regular bank loans to firms or contractors in the construction industry because they see such loans as too risky.
Commercial Construction Loans
Commercial construction loans are specialized loans that are offered only to businesses or borrowers in the construction industry. These loans, however, can also be tough to obtain. Many banks and other financial institutions that offer construction loans or financing may require exhaustive paperwork and documentation to be submitted and reviewed in detail before extending construction financing, more so than in many other industries that small businesses may be operating in.
For example, banks and financial institutions often will require borrowers to not only provide the construction documents like the signed construction contract and will require that the potential borrower also submit the actual construction plans themselves. The bank or financial institution will then review these in great detail before deciding on a financing application.
Securing commercial construction contract financing requires multiple steps and patience. The lender will typically require that the borrower sign a legal document guaranteeing that all payments on that contract will flow through a controlled bank account until the loan is paid off. Unlike many other types of loans or financing, which may require a personal guarantee from the owner of the business, but will not require the use of a controlled account of this type.
In contrast to some other construction loans, the borrowed dollars are restricted specifically for expenses for that particular job(s). They police this by monitoring the flow of funds into and out of the controlled account. Commercial construction lenders typically require that the borrower has been in business for at least two years and be able to provide bank statements and some financial documents. The loans usually only require that interest gets paid before the project is completed.
Lines of Credit
Much like a bank loan, a line of credit usually gets selected through a bank or other financial institution. Rather than being allocated to a particular project, a line of credit is instead a set amount that can be used by the borrower for many different uses, as the need for additional financing or capital may arise.
If a $100,000 line of credit gets approved for a particular business and it draws out $95,000 to purchase materials and equipment for a project, then only $5,000 is left for it to draw on to use to pay its employees or some other purpose. Until the $100,000 has been repaid, the borrower cannot draw any more money out. Given that a line of credit is extended for use on any number of reasons, lenders will want to have an overview of the overall business and its track record in construction. The company will often need to show a sustained record of profitability that will provide assurances to the lender that any funds will be paid back as they are drawn out by the borrower.
An Advance against your future Receivables
One of the options for construction businesses in need of financing is an advance against future projected income or receivables. An advance can provide flexibility for construction businesses that need financing to complete a project, begin a new project, obtain new equipment, or maintain or refurbish existing equipment.
Construction businesses face unique problems in the industry, such as being required to self-finance some portions of the construction process. Having access to a guaranteed form of funding any time you need it can be a significant stress relief. Our Receivable Advances can be secured with much less paperwork and lag time than other forms of financing for construction-related businesses. Approval rates are also much higher than most of the different financing forms discussed above.
Successfully Managing Construction Financing: Proper Planning is Essential
Regardless of what kind of construction financing or loan you end up utilizing, a few steps will ensure that you are successfully able to repay the financing or loan on time. Proper planning is the first and most important of these tasks. Although it is impossible to foresee all of the issues that may arise in the context of a construction project, certain contingencies that affect the bottom line of a project can get managed with proper foresight and careful planning.
Every construction project runs either over budget or behind schedule or both at various points during the construction process. Given that it is inevitable that this will occur, building some wiggle room into the construction contract, as well as the repayment schedule of any financing your construction may obtain, is particularly important. Ensuring that you do so can help you and your business to successfully weather whatever problem comes up without running out of funds or needing to seek emergency financial assistance.
Whether you’re a contractor, subcontractor, or other construction-related business, our merchant cash advance can provide you with working capital to help you get started on a new project or help drive a project across the finish line.
Other Available Options
Your construction business needs a backhoe, skid steer, dump truck or any other type of heavy equipment. Having one will cut future building costs by eliminating at least one sub-contractor. Scheduling may also be easier to manage producing a shorter timeline which is also a cost-saving. Construction equipment, even used machinery, however, is not inexpensive.
Few contractors would have the working capital to purchase outright or to rent equipment. A solution is heavy equipment financing enabling business owners to keep some degree of liquidity while (literally) moving their business forward.
Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. … Factoring is commonly referred to as accounts receivable factoring, invoice factoring, and sometimes accounts receivable financing.
A finance lease (also known as a capital lease or a sales lease) is a type of lease in which a finance company is typically the legal owner of the asset for the duration of the lease, while the lessee not only has operating control over the asset but also some share of the economic risks and returns from the change in the valuation of the underlying asset.
More specifically, it is a commercial arrangement where:
1. the lessee (customer or borrower) will select an asset (equipment, software);
2. the lessor (finance company) will purchase that asset;
3. the lessee will have use of that asset during the lease;
4. the lessee will pay a series of rentals or installments for the use of that asset;
5. the lessor will recover a large part or all of the cost of the asset plus earn interest from the rentals paid by the lessee;
6. the lessee has the option to acquire ownership of the asset (e.g. paying the last rental, or bargain option purchase price);
A finance lease has similar characteristics to hire purchase agreements and closed-end leasing as the usual outcome is that the lessee will become the owner of the asset at the end of the lease, but has different accounting and tax implications. There may be tax benefits for the lessee to lease an asset rather than purchase it and may be the motivation to obtain a finance lease.