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What is government contract financing?
Every year, the U.S. and Canadian governments award billions of dollars of contracts to small and medium-sized enterprises (SMEs) to help create jobs and foster long-term economic development.
While working with a government entity may be a lucrative opportunity, many SMEs have to fund upfront costs and other operating expenses before being able to take on a project. They also have to wait for the government to pay invoices — which can take one to two months. Government contract financing helps businesses obtain the working capital they need to successfully put together bids and monetize invoices after the contracts are completed.
What types of government contract financing options exist?
Businesses can finance government contracts through factoring, asset-based lending, or the Small Business Administration (SBA) loans. Contact Business Factors today to find the best alternative for your business.
The best financing option ultimately depends on your business’s unique situation. For instance, if the business needs immediate capital but has minimal assets, factoring can be a good option. If the company has at least $1 million in eligible assets, including inventory and accounts receivable, and these assets are not pledged to another lender, asset-based lending could be a good choice. If your business meets SBA requisites– two or more years in business, sufficient equity, etc.– such a loan or revolving facility may be a good option.
Sometimes known as accounts receivable factoring or invoice financing, factoring is a quick way to monetize outstanding invoices at a discount by selling them to a bank or a specialized factoring company.
The advantages of factoring are:
- It is good for businesses with short credit history because relies on the creditworthiness of the client (i.e the government), not your own.
- It requires less paperwork and has fewer eligibility requirements than a bank loan.
- It is not a loan. Rather, it is an outright sale of invoices to a factor.
- It is flexible. You can sell a couple invoices (a transaction known as spot factoring) without signing a long-term agreement.
The advantage of factoring is that it relies on the creditworthiness of the client (i.e the government), not your own, making it ideal for businesses with short credit history.
The caveat of factoring, however, is that the government contracting officer has to agree to the assignment of payment to a third-party. Once that is done, the factor takes over the responsibility of collecting payment from the government on the client’s behalf.
Factor can take full responsibility for collecting on the invoice, regardless of how long it takes. This option is known as non-recourse factoring. There is no chargeback to the client if the invoice is not collected. Factors always run a credit check on your client before agreeing to purchase the invoice.
Conversely, the factor can agree to extend the funds for a limited period of time (say, two months). If, after that time, the invoice is not collected, the client has to repay the factor or replace the invoice with a new, creditworthy one. This, more common arrangement, is known as recourse factoring.
Government contract factoring is initiated when the factor is provided with a copy of the invoice. The factor then advances a portion of the outstanding amount and holds the rest as reserve. Once the invoice is paid, the business gets the remainder minus the discount rate and any additional fees.
Let’s take a look at an example:
- Invoice amount: $10,000
- Advance rate: 85%, or $8,500
- Reserve: 15%, or $1,500
- Discount rate: 2.19% ($219) every 30 days until the invoice is collected
- Type of arrangement: non-recourse
In this example, the factor provided $8,500 upfront and kept the rest as reserve. The fee was $219 every 30 days. Let’s assume the invoice was collected in two months. The total fee was $438 and the factor would return the remainder of the reserve ($1,062) back to the client. If the invoice was outstanding for longer — 3 months for instance– the factor would charge $657 and return $843 to the client. The arrangement was non-recourse meaning there would be no chargeback to the company if the invoice was not paid.
For more information on factoring, please see our Invoice Factoring, Small Business Factoring or Accounts Receivable Financing pages.
Asset-based lending (ABL)
Asset-based lending is a type of lending where funds are extended based on the value of a company’s most liquid assets, such as their accounts receivable and inventory. The amount advanced can’t exceed the so-called “borrowing base” which is the value of the eligible assets minus a discount determined by the lender.
ABL can come in the form of a loan or a revolving credit facility, also known as a revolver. A loan allows the business to borrow only once. Meanwhile, amounts available under a revolver can be reused after they are paid down. Lenders, unlike factors, do not take ownership of the receivables. For other differences between factoring and lending, please refer to our ABL lending page.
For an example of a borrowing base calculation, please refer to our Accounts Receivable page. Lenders can charge a commitment and an unused line fee on top of the interest rate.
To qualify for a loan, companies typically need at least $1 million of eligible assets and be in business for over 6 months. It may be tricky to secure a smaller loan, because, from a lender’s perspective, the cost to monitor a loan is similar regardless of its size.
Here is an example of a borrowing base calculation:
|1||Eligible accounts receivable||$90,000||$120,000||$130,000|
|2||Loan availability on accounts receivable (Eligible A/R by 85%)||$76,500||$102,000||$110,500|
|4||Raw materials (100% eligibility)||$50,000||$60,000||$70,000|
|6||Finished goods (100% eligibility)||$10,000||$20,000||$15,000|
|7||Total eligible inventory||$60,000||$80,500||$85,000|
|8||Inventory advance rate (multiply line 7 by 50%)||$30,000||$40,000||$42,500|
|9||Inventory cap (maximum amount against which the client can borrow)||$50,000||$50,000||$50,000|
|10||Loan availability on inventory (the lesser of line 8 and 9)||$30,000||$40,000||$42,500|
|11||Borrowing base for this report (sum of line 2 and 10)||$120,000||$160,000||$172,500|
In this example, the lender extends a revolving line of up to $200,000. The amount that can be drawn, however, is determined by the value of the underlying assets (line 11), which is the borrowing base. As the value of these assets goes up and down, so does the borrowing base. The maximum amount that can be borrowed, however, is capped at $200,000. However, if the business grows and the value of the assets consistently exceed the credit limit, it may need to ask the lender to increase the borrowing base.
For more information on asset-based lending, please refer to our Asset-based Lending or Accounts Receivable Financing pages.
SBA loans are loans and revolving facilities for small-business that are partially guaranteed by the Small Business Administration. The advantage of this option is that it can have lower fees and interest rate than other loans. The downside is that these facilities might be hard to qualify for. With a properly put together application package, however, your chance of qualifying goes up. Talk to one of Business Factors & Finance experts today to get started with the application process.
In order to be eligible for an SBA loan businesses must:
- Operate for profit
- Be engaged in, or propose to do business in the U.S. or its territories
- Have sufficient equity
- Use alternative financial resources, including personal assets, before seeking financial assistance
- Have the ability to repay
Individual lenders may also set their own requirements for applicants, including the interest rate.
Qualifying for SBA loans is easy if you know how to put the application package together. Talk (https://businessfactors.com/contact-us/) to one of Business Factors’ experts about how to increase your chances of qualifying for an SBA loan and we will get the process moving for you.
SBA’s flagship 7(a) General Business Loan Guaranty Program is the most versatile option. The proceeds can go toward:
- Working capital
- Fixed assets acquisition
- Debt refinancing
- Land purchase
At the same time, loan proceeds cannot be used to:
- Repay delinquent taxes
- Effect a change in the ownership of the business
The maximum loan size is $5.5 million. In 2018, the average loan size stood at $420,401.5, according to a March 2018 Congressional Research Service paper. Business Factors & Finance specializes in SBA loans starting at $50,000.
Government contract financing can be useful for companies needing to finance upfront costs or operating expenses when working with a local, state or federal government. Options include factoring, asset-based lending and SBA loans. Factoring is the sale of outstanding receivables to a factoring company or a bank. A factoring company buys the invoice and provides cash upfront, minus fees and, sometimes, a reserve that is returned once the invoice is paid. Asset-based lending (ABL) can also be used to secure needed capital. Here, approved funds are based on the value of a company’s most liquid assets, such as accounts receivables and inventory. ABL financing can come in the form of a loan or a revolving credit facility, sometimes known as a revolver. Business loans such as SBA loans, can also help inject capital into a business. Business Factors can help you put together a successful application package.
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