Contract Financing: How It Helps Small Businesses Fulfill Large Orders

Landing a large contract can feel like hitting the jackpot for small business owners. Large orders can put you on the path to level up your business, but they typically come with significant upfront costs that you have to cover before you get paid by your customer. That's where contract financing steps in.

Contract loans are a specialized financing option that allows you to access working capital based on a signed contract. Contract loans are not traditional loans. Unlike traditional loans, which typically weigh your business's credit history and finances, contract loans are based on the creditworthiness of your customer. A lender provides you the necessary funds to cover the order and you repay the loan when you receive payment.

Here, we explore how contract financing loans work and how it’s different from similar funding options like purchase order financing.

In this article:

• How to work with contract financing companies and financial institutions to cover the cost of contract work.
• The benefits of leveraging business contract loans to meet your financing needs.
• What kinds of businesses can benefit from contract loans when they earn a new contract.

How Contract Financing Works

Let’s pretend your manufacturing company has just secured a $500,000 contract to build custom components for a government contract. It’s the biggest order your company has ever received, and to fulfill it, you’ll need to purchase $200,000 worth of raw materials, hire five temporary staff, and rent specialized machinery before you can even begin production. As a government contractor, you won’t expect to be paid for at least 30 days. You don’t have $200,000 cash on hand, so here’s how a contract loan works instead:

1. Secure the contract: Whether you’re working with the government or a private company, you should make sure you have a clear, signed contract in place. The contract should clearly outline the scope of work, payment terms, and the total contract value. The lender will view the contract details and the creditworthiness of your customer in the loan application.
2. Apply for contract financing: Traditional financial institutions, online lenders, and specialized contract financing companies all may offer contract loans. On the financing application, you’ll typically provide a copy of your signed contract, as well as financial statements and other business documentation.
3. Lender approval: After the lender does due diligence on both your company and your customer’s, they’ll typically offer an advance as a percentage of the total contract value.
4. Start working: Once you receive the advanced funds, you can purchase necessary raw materials, cover labor costs, acquire necessary equipment, make subcontractor payments, and address all of the other upfront costs related to fulfilling the contract. With the working capital you get from the contract loan, you’ll be able to fulfill the large order on schedule.
5. Client pays: Finally, when the client makes payments based on the contract’s terms (either in full upon completion or on milestones), the money is sent directly to the business loan finance company — whether it’s a bank or a specialized lender. Usually, the client pays the lender directly, but with borrower-controlled contract loans, the client may pay your company directly, and then you’re responsible for paying the lender.

The contract loan fund gives your company the cash flow necessary to fulfill the order and establish a blueprint for meeting major orders in the future.

Benefits of Contract Financing for Small Businesses

There are many advantages of contract loans for small businesses:

• Access to working capital: You don't have to wait weeks or months for client payments. This immediate liquidity lets you get to work quickly.
• Ability to fulfill larger orders: Contract financing breaks down the financial barriers that often prevent small businesses from bidding on and executing major contracts.
• Less reliance on traditional collateral: Conventional term loans or other types of small business loans often require collateral, like real estate or business equipment. Contract loans use the contract itself as collateral, making it a more accessible option for businesses without a lot of hard assets.
• Flexible funding: Contractor financing is typically tailored to specific projects. The repayment terms are aligned with your contract's payment schedule, making it a flexible funding solution for project-based businesses.
• Improved client relationships: When you get the capital you need to fulfill a large order quickly, it can help create a stronger relationship with your client that leads to repeat business and referrals.

Eligibility Criteria for Contract Loans

Contract financing tends to be much more accessible than traditional financing options. Rather than having to show your personal or business credit score or meet annual revenue and time in business requirements, lenders are more concerned with your client’s creditworthiness. The most important eligibility criteria lenders look at include:

• Contract: Most importantly, you need a legally binding contract from a creditworthy client. Lenders will review the terms, payment schedule, and scope of work when assessing your application.
• Client’s creditworthiness: Lenders are betting on your client’s ability to pay, so their financial strength and payment history are more important than yours.
• Your ability to fulfill the contract: Lenders want assurance that you have the operational capacity, experience, and resources to complete the work outlined in the contract successfully.
• Duration of the contract: Short-term contracts are sometimes preferable, but long-term ones with defined milestones will also help lenders recoup their money faster.

The Difference Between Contract Financing and Purchase Order Financing

It's common to confuse contract loans with purchase order (PO) financing, as both provide upfront capital for fulfilling orders. However, there's a critical distinction in what is being financed.

Contract loans are a type of financing that provides funds before any work has begun. It’s based on the value of a contract for goods that have yet to be manufactured. For instance, a construction company may use a contract loan to buy steel and concrete to fulfill a contract to build an office park.

Purchase order financing is specifically for businesses that need to purchase finished goods from suppliers to fulfill an order. In this case, the lender pays a company’s supplier directly for the goods, which are then shipped to the customer. Once the customer pays the invoice to the lender, the lender then pays you the remaining balance after removing their fees. For instance, a distributor may receive a large purchase order for imported electronics and use PO financing to pay their overseas manufacturer for the goods, which are then shipped to the customer.

Both are valuable tools, but choosing the right one depends on your specific business model and financial needs.

Industries Utilizing Contract Financing

Contract loans, like the name suggests, are best used in contract-based industries. These may include:

• Manufacturing: Manufacturers often require substantial capital for raw materials, machinery, and labor long before they deliver finished products.
• Construction: Construction companies often have major upfront expenses. Payments often lag behind costs, making contract loans particularly useful.
• Government contracting: Businesses that work with the government often have significant regulatory hurdles and lengthy payment terms. With contract loans, these businesses can bridge funding gaps, making them more competitive in the lucrative government contract space.
• Technology services: Businesses that provide large-scale software development, IT infrastructure projects, or system integrations can require significant investment in specialized talent and technology upfront, with payment tied to project milestones.
• Energy and environmental services: Projects in green energy, such as renewable energy installations or environmental remediation, often involve considerable initial outlays for specialized equipment, permits, and labor.

How to Choose the Right Contract Financing Lender

Here’s what to look for when you’re comparing financial institutions or contract financing companies:

1. Industry specialization: You should look for lenders that have specific understanding of your industry’s unique challenges and risks.
2. Experience and reputation: Read reviews and testimonials, try to speak with other business owners who have worked with the lender, and evaluate their experience and reputation. It’s always a good idea to ask for references.
3. Fees and terms: Unlike other loans, contract loans have fees rather than interest rates. You should always ensure you fully understand all costs involved, including any penalties for late payments or early termination.
4. Flexibility: Contract loans should be flexible to meet the cash flow needs of your business and project. As such, you should try to work with a lender that can adapt to changes or delays.

Final Thoughts

Contract loans are often better structured than other loan programs to support your immediate, project-based needs. This makes them particularly useful for contractors in manufacturing, construction, and government-backed projects. With contract financing, you can overcome the initial hurdles of upfront costs to accept large, more profitable orders that will help grow your business. With a clear understanding of how it works, its benefits, and how to choose the right partner, you can confidently leverage this funding solution to turn formerly ambitious contracts into realistic ones.

FAQs About Contract Loans

Is contract financing a loan?

While often referred to as contract loans, contract financing is typically not a traditional loan. Instead, it's an advance based on the value of a specific contract. The repayment comes directly from your client's payments for that contract, rather than from your business's overall revenue.

What's the main difference between contract financing and invoice factoring?

Contract financing provides funds for work before it begins, based on a signed contract. Invoice factoring, on the other hand, provides immediate cash for existing, unpaid invoices (accounts receivable) for completed work.

Can startups or new businesses qualify for contract financing?

Since contract financing weighs the creditworthiness of your client rather than you, new businesses with limited operating history or collateral may have a good chance of qualifying for contract financing, provided the client has a good track record.

How quickly can I get approved for contract financing?

Contract loan approval times vary, but they’re typically faster than traditional bank loans.

What if my client doesn't pay the contract on time?

The terms regarding client non-payment depend on the specific agreement with your lender. Some contract loans are "non-recourse," meaning the lender bears the risk of client non-payment (under certain conditions). Others are "recourse," meaning your business is ultimately responsible for repayment if the client defaults. Always clarify these terms with your chosen lender.

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