Whether you’ve been in the contracting business for a while or are just getting your feet wet, there will inevitably come a time when you need a little extra cash. Maybe you need enough working capital to make it through a specific project, or maybe your business is facing a general cash crunch. Either way, you’ve got options.
Construction businesses are usually considered “high risk” by traditional lenders, which means they may be more hesitant to offer financing. That doesn’t mean there aren’t other financing options available though. Here are our top recommendations on construction financing for contractors (and how negotiating upfront mobilization can help you avoid going down this route altogether).
Key Takeaways
- Contractors can use several different financing options to overcome long cash conversion cycles on projects.
- While some types of construction financing are riskier than others, you as the borrower always run the risk of defaulting.
- To avoid running into trouble, we always recommend asking for a down payment (aka “mobilization”) from project owners so you can bypass having to fund jobs from your own pocket.
When Should Contractors Use Financing Options?
The construction industry isn’t known for instant gratification. Oftentimes, general contractors have to finance construction projects upfront, then wait for months to even start collecting payments. This makes cash flow management tough, especially for up-and-coming business owners without a stockpile of extra cash or liquid assets on hand. Construction financing can help fill in these gaps so you can make it through projects and continue to grow your business.
How Contractor Financing Works
The first thing you want to think about when deciding whether or not to use financing is your gross margin. Look at this margin as the percentage you would expect to pay on a job, and the interest rate you would pay for the financing.
Let’s say you take out a construction loan at 10%. Your gross margin is only 8%, so you know you’re going to lose 2% no matter what happens. If you had a gross margin of 25% though, you’d still be turning a profit at the end of the day. All this to say, sometimes it’s not worth taking jobs that would require a business loan because you’ll just end up losing money.
Here's a more detailed example of how this would work:
- You’ve won a $10M construction job. The project will be completed over 12 months with a 7% gross margin. This means you would earn $700,000 in gross margin once the project is done and you’ve been fully paid.
- You’ll average $350,000 out of your own pocket for 11 months of the project, starting in month two.
- You decide to use a credit line to fund that $350,000.
- Because of retainage, you won’t be fully paid until month 13. You’ll have to finance the project for 12 months and then pay off your credit line.
- At a 10% interest rate, you will pay $35,000 to do this job.
- After you pay interest, you’ll end up earning $635,000 for the project.
Financing isn’t a one-size-fits-all solution, nor is it always the best option. That being said, you should still know what your options are.
👀 Want to learn how to create a better system for tracking all your financials? Check out our complete guide to construction accounting for emerging contractors.
7 Types of Construction Financing for Contractors
Below are the most common types of financing available to contractors today.
1. Credit Lines
When a project needs more funds to get out of a temporary cash crunch, tapping into a line of credit can help. The nice thing about a credit line is that once you’re approved for a certain amount, you can draw from that pot whenever you need it, making it a good short-term financing solution.
Ideally, you’ll already have gone through the application process of establishing a credit line through your bank or credit union before you need it, because getting one can take at least a month. To get approved, a financial institution will look through your personal and business information to determine your eligibility, including:
- Your overall creditworthiness, including your credit score and credit history
- Your financial statements
- How long you’ve been in business
The downside to a credit line is that the owner of the business applying usually has to personally guarantee it.
2. Fixed-Term Loans
A more out-of-the-box approach would be to get a fixed-term loan. These types of loans have an interest rate that stays fixed throughout the entire term. If you have a larger project coming up that’s outside the realm of what you’re used to, this could be a good loan option.
For example, you won a $30 million project that will take you two years. You know your cost to complete will be $20 million, and you want to make sure you don’t run into any backstops. Your bank may be able to provide a fixed-term loan for the project’s duration. You’ll just need to make sure the interest rate you’re paying isn’t higher than the gross profit you expect to make on the job. You’ll need to calculate the biggest amount you believe you’d be out of pocket during the job to bridge your cash needs.
3. Borrow from Your Business Assets
If you’ve been in business for a while, you probably have hard assets like buildings or equipment that you’ve either paid off or have equity in. If you need cash, some lenders will offer you a secured loan against one or more of these assets.
Depending on the assets, this can be a quick way to get the financing you need. Just be warned, the better rates you get come with higher risk. If you can’t pay up, your assets will be taken.
Another way you can do this is by borrowing off the amount of cash (or equivalent in operating accounts) you have in your business. The downside of this method is that your cash essentially becomes restricted, and if it goes below a certain balance, you would owe part of the loan amount.
4. Factor Your Receivables
If you really need quick cash, you can get a loan on your receivables. It’s not a long-term answer to cash flow problems, and it’s not a solution we recommend often, but it’s something you can do if you need it.
In this type of loan, a company will pay you a percentage of your invoice that’s due upfront, instead of waiting for it to come through in the standard amount of days. For example, a company pays you 97% of your receivables and pockets the remaining 3%. This is a huge return for them.
Let’s take the math even further. 30 days divided by 365 equals 12.16 times a year the factoring company could loan. 3% time 12.16 is an annualized 36.5% rate of return for the loan company. As a contractor, you’re giving up a lot in this scenario, which is why we recommend exploring other types of financing first.
5. Ask for Better Repayment Terms
It’s a smaller lever, but asking for better payment terms can give you a bit more breathing room, especially if you buy a lot of materials. When you can, negotiate “pay when paid” terms so you don’t end up in the hole.
6. Sell a Piece of Your Business
If you find yourself consistently in a cash crunch, it could be worth selling part of your small business. This is a big decision, and requires really thinking ahead about your company’s value and your long-term goals.
Selling a portion of your business means you can get a return on the time and resources you’ve put in over the years. Diversifying ownership also means you’ll inherently take on less risk. On the other hand, more cooks in the kitchen could lead to disagreements on long-term vision and strategy. Like every other financing method, you have to weigh the potential value over the drawbacks.
One question you’ll need to think about is whether or not you’d maintain majority ownership in your business. As an operator of the business, we’d recommend maintaining this. Lastly, you should also think about establishing a buyout clause that benefits all parties for anyone interested in buying in.
7. Credit Cards
Lastly, you can always use your business credit card at major suppliers like Home Depot to defer payments for a bit. It’s a bottom-tier solution when it comes to financing, but it’s always worth remembering.
How Down Payments Can Help You Avoid Financing Altogether
Financing is important, and can help your business grow, but it’s also very easy to get into trouble with. If you can’t make your monthly payments, your financing provider can raise your interest rates, take your equipment, or even sue you for nonpayment. This is why we always recommend asking for mobilization (or down payments) on projects upfront. This is the single biggest thing that can help you avoid financing.
Of course, not every project owner is just going to hand over money, so here are a few tips on how to increase your chances and make the most of down payments when you do get them:
- It should go without saying, but doing great work and building strong relationships with your customers over time will make it much easier to get a ‘yes’.
- Don’t be afraid to ask, even if you’re a newer contractor. Asking for what you need to make a job successful for you and the other parties involved gives everyone the opportunity to come out happy in the end.
- If you do receive mobilization for a job, don’t use it to fund another project.
If you tried your best but still got a ‘no’, don’t throw in the towel just yet. There are a few more things you can do to keep your cash flow up on projects:
- Ask for no retainage on jobs, or at the very least, ask for a retainage reduction rider.
- Make sure you’re retaining profit over time as you complete work. The more you build up your operating accounts, the better you’ll sleep at night.
- Figure out how much operating capital you need for the revenue level you’re at. This will help you when planning.
Wrapping Up
The construction financing options we’ve talked about can be good tools when considered carefully, but shouldn’t become a crutch. Instead, think of financing as something to help your construction company get over the initial hurdles of our industry’s long cash conversion cycle. Once you’ve built up a good reputation, asking for down payments upfront on projects will help you maintain a healthier cash flow and margin in the long-term, without the risk of financing.