Construction is historically an invoice-based industry. You get paid when work is completed, and only after the invoice is submitted along with other documentation and approved by multiple project stakeholders.
This payment process can take weeks or months, creating serious cash flow and working capital challenges for contractors who are waiting to get paid for work in which they’ve already invested payroll, equipment usage and materials.
Subcontractors are especially vulnerable to working capital gaps; the current strict lending climate for small to midsize businesses hampers access to quick financing at reasonable rates. But there’s a way for general contractors (GCs) to alleviate the financial pain of their valued project partners while accelerating invoice payments and without depleting their own working capital. It’s called supply chain financing (SCF).
How does it work?
In simple terms, SCF uses financial strategies that help buyers of goods and services (GCs) maintain or enhance their own working capital while improving the working capital and cash flow of their suppliers (subcontractors) through faster, more predictable payments. Although there are different types of SCF methods, let’s focus on the reverse factoring method, also known as approved payable finance.
Here’s how it works: A general contractor engages a third party to finance approved invoices on specified dates. Participating subcontractors receive their payments significantly earlier in exchange for a modest fee issued by the financer, which is tied to the invoiced amount. Once the project owner releases financing to the GC, the GC then pays the original invoice amount (no fee attached) to the third-party financer to close the payment loop.
SCF enables invoices to be paid much earlier than traditional processes do, and the fee charged to the subcontractor may compare favorably to the costs of traditional financing available to most small and midsize construction businesses because it’s based on the creditworthiness of the larger GC. SCF also allows GCs to extend their payment cycles to enhance cash flow during projects, as they pay the third-party funders later in the process than they would with other options.
Why should GCs do it?
With construction booming and skilled labor shortages troubling many areas of the country, close working relationships between GCs and subs are increasingly important. GCs can use SCF to build trusted relationships by ensuring their project partners have the resources they need to successfully complete work and move on to the next job.
Consider this: It’s not uncommon for subcontractors to run into cash flow problems because of unpaid invoices and a tight lending market. Delays in payment and uncertainties over when payments will be received can weaken subcontractors’ financial health, limit their ability to plan and mobilize, and even cause business failures.
When subcontractors default because of financial issues, GCs must face several challenges, including work stoppage and costly project delays as they seek to replace the sub in question. By employing SCF to accelerate invoice payments, GCs can stabilize their supply chains (dependable subcontractors) and build loyalty, which can bring about higher quality work in better time frames.
Meanwhile, subcontractors receive payments more quickly, often within days of submitting invoices, reducing their reliance on hard-to-acquire traditional financing. Some subs may enjoy an added benefit of being able to take advantage of suppliers’ early payment discount programs.
What are the risks?
Although SCF offers the advantages noted, contractors should view it as an alternative to traditional financing and seriously consider it only after a careful examination of the pros and cons.
The approach has its detractors, who advise against any form of factoring because of the inevitable degree of control you’ll lose to a third-party financer. Performing a cost-benefit analysis and checking the fine print of any prospective arrangement are imperatives.
Also, it should be noted that perhaps the ideal way to pay subcontractors, without incurring any outside interest costs, is to build up an in-house operating cash reserve to finance business activities.
How technology brought SCF to construction
Although supply chain financing (SCF) has been around for decades, the complex nature of the construction payment process has, in the past, prevented its widespread use in the industry.
Unlike many other business transactions, construction payments aren’t as simple as submitting an invoice for payment. Instead, they’re complicated dealings that require supporting paperwork, including certifications proving billed work has been completed and documentation related to compliance, liens and more. Add in the industry’s litigious nature, and SCF financers have traditionally seen construction as a high-risk investment.
Technology has changed that perception. Construction-specific business management and accounting software solutions have standardized and automated the invoicing and payment process. Developed specifically for contractors, they track all payment activities and help ensure invoices are clean and free of liens, which is key to making invoices eligible for SCF. When these tools are cloud-based, they make invoicing more transparent, placing all participants on a network where they can easily access information. With cloud-based platforms, it’s also faster and easier to add participants.
These technology tools have packaged construction invoices as fundable assets free of liens and other issues — and SCF funders have taken notice. If you’re interested, a quick Internet search will bring up several institutions that now offer SCF programs to contractors.
Who can help?
There’s no doubt that SCF holds promise for the construction industry — particularly as the technology facilitating the SCF process improves. As noted, it may not be a good fit for every construction company. Consult your CPA for a full assessment of whether SCF is right for you.
We welcome the opportunity to put our construction industry expertise to work for you. To learn more about how our firm can help advance your success, please contact Dave Wolfenden at (302) 254-8240.