If you provide any type of product or service on a subcontract, you’ll want to be aware of a Pay-IF-Paid subcontract. I’ve had a number of these subcontracts come across my desk recently. They make financing a bit more of a challenge for asset-based lenders. Large, prime and general contractors like to put this clause in their subcontracts. Usually, you will find the payment clause written something like, “If Contractor receives payment from Owner, Contractor agrees to pay Subcontractors within 30 days from receipt of payment by Owner.”

Why subcontractors may want to finance a contract:

There are a number of reasons why a subcontractor would want to finance a subcontract. Maybe the subcontractor has only been in business a few months, and has limited working capital available, but had an existing relationship to secure the subcontract. The subcontractor may be well-established and is taking advantage of an opportunity to grow revenue. Invoicing might be monthly but the subcontractor needs to make payroll every week or two. They do not have enough available cash or credit to cover a half dozen payroll cycles before receiving payment from the contractor. The subcontractor needs to mobilize and has to pay for hotels, travel, meals, and equipment rental up front before they can start work. A Pay-IF-Paid subcontract will make this more difficult.

A prime example:

A Southeastern trucking company received a subcontract award to supply dump trucks to a prime contractor on a Georgia Department of Transportation (GA-DOT) highway project. They were tasked with hauling aggregate from the supplier’s yard to various locations along the highway. The project was scheduled to last for 3-months. Per the Pay-If-Paid subcontract, the subcontractor could invoice once per month for the number of loads delivered to the job site in the prior month. The payment clause of the contract stated, “If Subcontractor is in compliance with this subcontract and if, and only if, Owner pays Contractor, and Subcontractor intends to assume all risk of nonpayment, Payments shall be due to Subcontractor no later than fifteen (15) days after receipt of payment from Owner by Contractor.” In this scenario, the contractor is only obligated to pay the subcontractor’s invoices IF they receive payment from the GA-DOT, the owner. If there is any delay or default in GA-DOT paying the contractor this would affect the subcontractor’s cash flow for the project.

How an asset-based lender provides financing based on the subcontract:

An asset-based lender will want to lend against, or purchase, the invoice that is generated at the end of the month. Usually they will advance between 70% to 90% of the invoice amount the same day that they receive a copy of the work-completed invoice. This will give the Subcontractor a quick cash injection rather than waiting 30, 60, or 90-days for payment. The lender will hold the invoice until the Contractor pays, then deduct their fees, and wire the remaining balance to the Subcontractor. This advance against a future receivable can then be used to pay the drivers, buy fuel, pay for maintenance on the dump trucks or cover operating expenses. If mobilization funding is required, and the client has additional assets they can pledge, the asset-based lender will front some funds to start the project and then factor the invoice at the end of the month to pay off the mobilization funding.

The challenge for asset-based lenders:

The challenge for an asset-based lender or invoice factoring company is that they need to know when to expect payment. They do not want to run the risk of non-payment any more than the Subcontractor does. NET terms are easy. Payment can be expected in 30, 60, or 90-days. With a Pay-IF-Paid subcontract the lender really has no idea when, or if, the invoice will ever be paid. This Pay-IF-Paid subcontract clause could cause the factoring company to refuse to purchase the work-completed invoices or provide financing based on the subcontract their client was able to secure. Most asset-based lenders or factors want to insure the receivables against non-payment through a credit insurance provider. Most credit insurance providers will not insure a pay-IF-paid invoice because their protracted default clause requires a set time between when the invoice is issued and when payment is due.

Other working capital options:

A traditional lender, like a bank, may consider providing a line of credit to the subcontractor for this Pay-IF-Paid subcontract if the subcontractor meets typical bank underwriting criteria. In business at least three years, positive cash flow, a high personal credit score, low debt-to-income ratio, etc. If the subcontractor does not qualify for a traditional line of credit, he may look at other working capital options. If she has good personal credit and equity in her home, she could apply for a Home Equity Line of Credit (HELOC). Although some business owners prefer to keep their personal and business credit separate. Another option might be a cash advance or MCA loan based on the last three months of business deposits. These loans usually have high interest rates and debit your business bank account daily or weekly, straining your already tight cash flow.

The solution:

Before executing a subcontract the Subcontractor needs to review the entire subcontract carefully paying particular attention to the payment clause. If they know they will need additional working capital to perform on the subcontract then they need to negotiate the payment terms. As noted earlier, NET-30, 60, or 90 is completely acceptable to most asset-based lenders and factoring companies. With NET terms they are able to purchase credit insurance against protracted default and bankruptcy of the Contractor. A little change like this could mean the lender will agree to providing working capital solely on the commercial credit quality of the Contractor and the subcontract. Without this change they will most likely require the subcontractor to pledge additional assets such as machinery, equipment, vehicles, or real estate in order to make sure the loan is overcollateralized. In the event of default, the lender can then liquidate the assets to get paid back.

I am always happy to assist my clients with a subcontract review. You can fill out the form on the Homepage,  book some time on my calendar, or just give me a call at (843) 790-3661.