Understanding contract finance

Money to complete contract work


Contract finance is the name given to a loan that is provided against a signed contract that your business has won, and the money must be used to complete the contract work.

Lenders are pretty fussy about which contracts they are prepared to finance since they need to be certain that the organisation that provided the contract will actually pay.  

This is what they look for:

  • A signed contract from a large, well-known private sector company.
  • A signed contract or tender award document from the government.
  • The total value of the contract. Few lenders will consider funding contracts with a value of less than R50 000.
  • Assurance that your company is capable of delivering the required services or products.
  • Assurance that the pricing is right and your business can afford the cost of contract finance.
No collateral is required for contract finance. In general, lenders prefer to finance a contract where you are the main contractor. However, they might consider funding sub-contracts, provided that the main contractor is a highly reputable company.

Letter of intent to fund a tender, RFP or high-value contract


There are occasions where a tender, RFP or contract submission will require proof that you have the financial resources required to complete the work. In this case, since you haven’t yet been awarded the tender, but need to submit a document stating that the finance required to complete the work is available, lenders are usually prepared to provide you with a letter that confirms that should you be awarded the tender, they will provide contract finance to enable you to complete the work.

In order to do this, you would need to visit the lender and give them documentation on your business. This will include: financial statements, bank statements, company profile and letters of reference from satisfied customers, the tender or RFP request document together with your response, project plan and budget. 

The lender will check these documents to make sure that you have the resources and knowledge to complete the work and, in particular, will look at the pricing to make sure that you will be able to afford the loan.

How contract finance works


Contract finance comes in different forms. The section below explains the different options for contract finance. Most lenders will want some means of either monitoring or controlling expenses and payments. The method they use will be determined by your professional reputation for delivery and the business trading history. The more established the business, the less need there is for the lender to control the finances.

Option 1: purchase order finance


Purchase order finance is a short-term loan or advance, secured by the purchase order or contract, to pay for inputs, raw materials, packaging, finished/trade goods for resale, etc. needed to produce and ship a product or deliver a service. Some lenders also provide purchase order finance that can be used to complete the contract work.

Option 2: the lender controls the money


In this case a separate bank account is opened and the contract loan amount is deposited into the account. The organisation that awarded the contract will make payments into this account according to the contract terms. The lender will have seen your project plan and will release funds for you to pay employees and buy the necessary supplies as agreed upon.

Obviously, to get the most from this type of finance, you need to build a close relationship with the lender. Good communication is important and will ensure that you have the money for the resources you need to complete the contract.

Once the contract is completed and payment has been made, the lender deducts their fees, deposits any remaining monies into your business account and then closes this account.

Option 3: watch over the money


In this option, you will have control over the finances and the contract. The money may be made available as a short-term loan or an overdraft (it really depends on the amount of finance required to complete the contract). The loan is only available for the duration of the contract.  

The bank will monitor the bank account transactions to make sure that you are managing the finances responsibly. Interest charges will be deducted from the account on a monthly basis, and the full costs of the loan must be repaid at the end of the contract.

It is important to keep the lender informed of any delays or amendments to the contract. If you maintain good communication with the lender, then it will be easier to resolve the problems caused by contract delays that are outside your control.

What might happen when things go wrong?


With this option, lenders have systems in place where they can put one of their own project managers in your business to take over the entire contract. Make sure that you read the contract finance document carefully to see whether there is a clause that states that the lender has the right to take control of the contract should your business encounter problems. 

With this option, lenders will monitor the contract work and step in to take control if you are battling to do the work. The lender then oversees the work and performs all the financial controls such as payments, payroll etc. In the event that the lender is forced to take control of the project, the cost associated with deploying their staff to execute your contract will be for your account.

The cost of contract finance


Contract finance is linked to the prime rate—although usually, it is a few percentage points higher. 

Other costs to consider are: 

  • A lawyer's fees to set up the cession documents (in this case, you will be ceding the contract to the lender).
  • Any transaction costs or management fees, in the event that the lender manages the finances.
  • Any fee associated with the lender having to supply project management and administration services associated with completing the contract.
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Finfind provides its services free of charge to businesses seeking finance. Our primary purpose is to link SMEs with all the relevant finance providers and finance products that match their funding needs. As a matching service, we are not required to be a registered finance provider as we do not loan money directly.