January-February 2011

r e p r i n t January-February 2011 CONSTRUCTION FINANCIAL MANAGEMENT ASSOCIATION The Source & Resource for Constr uction Financial Professionals

BY EARL HARPER THE COST OF MONEY: Factoring Working Capital SOURCES OF CAPITAL The most obvious source of capital although usually the most challenging is a contractor s own cash. If the use of internally available capital leads to additional projects that result in increased profitability for a company, then that cash should be used for working capital. Unfortunately, since backlogs have been dramatically reduced (if they exist at all), the availability of internal working capital continues to be very scarce. The preservation of that capital is essential to longterm success. The second most common source of capital is a revolving line of credit from a commercial bank the next best thing to a contractor s own money. Access to cash and cash management are crucial to survival in today s construction environment. There are several forms of capital available to contractors today. According to A CFM s Guide to Outside Capital: Uses, Forms, Advantages & Disadvantages (by Aaron B. Bachik in the May/ June 2010 issue), those forms of capital include senior debt, subordinated debt, and institutional private equity. Now, let s take a look at the sources of capital. If an adequate commercial line of credit is available, it should be the primary source of capital. It s usually the most reasonably priced (currently 1-1.5% per month) and is secured by a blanket lien on all company and personal assets, including receivables. And, if properly maintained, it results in building the essential banking relationship a contractor needs for all other financial services commercial banks provide. Conventional commercial financing requires the availability of collateral to secure a loan. More importantly, it also requires a willingness to lend to contractors, particularly those working on publicly funded projects that require surety bonds (which usually have first lien position on project receivables). CFMA BP January-February 2011

the cost of money Factoring Working Capital In the absence of a conventional source of funds, an alternative albeit usually more costly source is through a factor that specializes in providing working capital for contractors. THE BASICS OF FACTORING A factor is a secured lender that purchases a contractor s receivables on a project. In return, the factor advances 75-80% of the invoice specifically to pay a project s job costs for which the receivable is purchased. The remaining 20-25% of the invoice that is not advanced provides an accounting reserve for the factor until the invoice is paid. Then, the balance net any outstanding fees is paid to the contractor. A factor typically establishes a line of credit based on the estimated amount of outstanding funds a contractor will have at any given time on all projects that require factoring receivables. The availability of funds against that line is based on the eligible receivables a contractor generates on projects that have been approved for factoring. Borrowing vs. Factoring When considering this type of financing, it s important to understand the distinction between borrowing money (with the receivable as collateral) and factoring. When the receivable is collateral, borrowed money is paid directly to the contractor, who usually has discretion over the use of those funds. The lender is in line with all others who have advanced credit to the contractor (although some have priority over others). With factoring, the receivable is actually purchased by the factor. So, the factor is paid the amount of the receivable directly by the payer (owner, or GC if the contractor is a subcontractor). In most cases, the payment is still made in the name of contractor, but is sent by the payer to a trust account controlled by the factor. Types of Factors There are two types of factors in construction: Recourse and Non-Recourse. A Recourse factor will usually only carry a receivable for 90-120 days. After that, the borrower will have to buy back the receivable, usually by replacing it with a more current one or paying the factor back out of personal or company capital for all funds borrowed. A Non-Recourse factor will usually charge a higher fee due to its increased risk of capital; it will buy the receivable and take direct action to collect funds owed when the receivable is 90-120 days. RESISTANCE TO FACTORING There is considerable resistance by GCs, sureties, and in some cases, project owners to the use of factoring throughout the construction industry. This resistance is understandable if the contractor who factors the receivables has any discretion over the use of the borrowed funds. There have been cases where a subcontractor factored receivables on a project and used the funds for other than job costs, resulting in claims and liens by subcontractors and suppliers who were not paid. This causes an owner or GC to pay directly for the goods and services used by the factoring contractor. To encourage acceptance by all related parties, the factor should employ a funds control program. This type of program is essential in construction factoring, and provides periodic reports that verify all advanced funds are only used to pay job costs on the specific project that the factored receivable is from. (For more information on factoring, including details on funds control programs, read Factoring: A Source of Working Capital for Contractors in the November/December 2010 issue.) COSTS OF FACTORING There are several costs of factoring receivables that must be considered, included in job costs, and accurately reflected in the company s financials. (See page 50 for two case studies.) Application or Due Diligence Fee This fee ranges from no cost (which is rare) to $1,500 if included in the initial financing fees. The industry average is $500-1,000 and covers the costs of all corporate and personal credit searches, underwriting, due diligence, document preparation, etc. Many factors do not charge a fee for preliminary underwriting to determine if a contractor qualifies for a factoring program. After preliminary underwriting is completed, a factor will prepare a proposal (or term sheet) that presents the maximum approved line of credit at any given time, as well as the financing terms and conditions. If the contractor accepts the proposal, it must then return it to the factor with the application or due diligence fee to complete the underwriting process. Then, the contractor is set up in the factoring program. Commitment or Loan Origination Fee Many factors charge this fee as a percentage of the total amount of the approved line of credit. It is usually paid during January-February 2011 CFMA BP

loan document signing or at the time of the first funding, provided that first funding occurs within 30 days of the loan document signing. This fee is usually 1-3% of the total amount of the approved line of credit. The entire fee or a percentage is usually charged annually upon renewal of the line. If the contractor needs to increase the line during the year due to increased financing requirements, a commitment fee is charged for the approved increase and prorated for the remaining portion of the anniversary year. Minimum Monthly Fees/Time Period Commitments Factors that do not charge a commitment or loan origination fee typically require a contractor to either borrow a certain amount each month, quarter, or year, or pay a minimum monthly fee. Those factors will also require the minimums to be paid for a six- or 12-month period, with early termination fees that cover the balance of the minimum payments if the contractor opts out of the contract before the anniversary date. Advance Discount Fee This is the initial amount charged for factoring an invoice or pay application. It covers a period of time specified by the factor in the loan documents (typically 30-45 days). The advance discount fee can cost 2-4% of the face amount of the invoice being factored. If the factor advances 75% of the face amount of the invoice and charges an advance discount fee of 2%, then the actual cost of funds advanced is closer to 2.5% for the first 30 days. Factoring Fee This fee is charged for all outstanding invoices beyond the period covered by the advance discount fee of 30-45 days. It can range from 2-3% or more for every 30 days that the factored receivable is outstanding beyond the original 30 days. Some factors prorate the fee on a daily basis. Others charge a 1% fee in 10-day increments, locking the fee in on the first of the 10 days regardless of when payment is received. Funds Control Fee As discussed earlier, a factor that specializes in construction must employ a funds control program to ensure that funds advanced against contract receivables are only used to pay job costs. The funds control program must balance all advances against the project budget and the schedule of values. A trust account is established in the name of the contractor through which all advances are paid, with monthly reports provided to all parties with a financial stake in the project. The fee for this service is usually 1-1.5% of the amount of each invoice factored. Total Cost The total cost to factor the receivables on an entire project, if the invoices are paid in 45 days or less, averages 4.5% of the amount of the project. Since all projects are different, it s essential to create a cash flow model in order to accurately budget these costs. CONCLUSION The good news: Working capital is available to lend to qualified contractors through factoring their receivables. Controlling the use of that capital can allow a contractor to increase capacity, as well as reduce material costs and subcontracted services. The challenge: Gaining acceptance for factoring by sureties, GCs, and owners who can ill-afford to jeopardize the success of their projects through the misuse of borrowed funds. If all parties work together, they can provide the capitalization contractors need to successfully accomplish the projects they have been (or will be) awarded within their capacity. n EARL HARPER is the Senior Vice President of RMP Capital Corp., a national factor headquartered in Islandia, NY. With nearly 20 years experience in contractor financial management and employee benefits administration, he is responsible for the business development of RMP s construction, contractor, working capital, financing, and finan-cial administration programs. Earl is the President and a Board member of CFMA s Central Texas Chapter. He is also a member of the AGC, ABC, the Hispanic Contractors Association of San Antonio, and the Central Texas Surety Association. Earl earned a BS in Political Science from Iowa Wesleyan College, Mt. Pleasant, IA, and is a graduate of the U.S. Army War College, Carlisle, PA. Phone: 512-658-4526 E-Mail: eharper@rmpcapital.com Website: www.rmpcapital.com CFMA BP January-February 2011

the cost of money Factoring Working Capital the costs of factoring: Two case studies Concrete Contractor (as a Subcontractor) on a State Department of Transportation Project Approved Line of Credit: $200,000 Advance Rate: 75% Advance Discount Fee: 2.25% for the first 30 days Factoring Fee: 2.25% for all outstanding invoices after 30 days Funds Control Fee: 1% of the contract amount payable at the time of processing each invoice factored Project Cost: $965,000 Retainage: 5% Project Duration: 6 months Average Invoice: $150,000, net of retention ($142,500) (Note: Most factors will not advance for retainage and will net that out of the face amount of the factored invoice.) Average Aging of Invoices: 30 days Average Advance: $106,975 to cover payroll, material costs, job-specific overhead, etc. Average Cost of Factoring per Invoice: Advance Discount Rate = $3,206 for the first 30 days Funds Control Fee = $1,425 Total Average Cost per Invoice: $4,631 Total Real Costs for Factoring the Project: Advance Discount Fees: $20,627 Funds Control Fees: $9,650 Total Cost: $30,336 (approximately 3.1% of the total project) Note: Forty-five percent of the contractor s cost on the project was for materials and 20% for subcontractors. The ability to pay subcontractors and suppliers in net 30-45 days or less allowed the contractor to reduce subcontractor and supplier expenses by more than 7.5%. So, factoring enabled project profitability for the subcontractor. Drywall Contractor (as a Subcontractor) on a Large VA Facility Approved Line of Credit: $400,000 Advance Rate: 75% Advance Discount Rate: 2.25% for the first 30 days Factoring Fee: 2.25% for all outstanding invoices after 30 days Funds Control Fee: 1% of the contract amount payable at the time of processing each invoice that was factored Project Cost: $1 million Retainage: 10% Project Duration: 12 months Average Invoice: The first invoice was $350,000 and covered a substantial amount of material costs. The next three invoices averaged $100,000 and covered mostly payroll, but also additional material. By the fifth month, the contractor was operating with positive cash flow and did not need to factor additional receivables. However, the contractor kept the funds control program in place for the duration of the project in case she needed to factor additional receivables toward the end of the project. Average Aging of Invoices: 30 days Advances and Fees for the Four Invoices Factored: Invoice #1 Advance was $236,250 and fee was $7,088 Invoices #2-4 Advances totaled $67,500 and fees were $2,025 each Funds control fee was 1% of the face amount for each invoice, net of retainage (a total of $5,850) Total Real Costs for Factoring the Project: Advance Discount Fee: $13,163 to borrow $438,750 Funds Control Fee: $10,000 (since the contractor used funds control on the entire project) Total Cost: $23,163 (approximately 2.3% of the total project) Note: The ability to pay subcontractors and suppliers in net 30-45 days or less allowed this contractor to reduce those expenses by more than 10%, turning the factoring into a profitable subcontractor. In addition, since she used funds control on the entire project, she was able to negotiate additional credit for both subcontractors and suppliers in the later stages of the project. January-February 2011 CFMA BP