Lines of Credit, Term Loans, and Factors
We briefly discussed credit cards which, while necessary, should not be your main source of capital, especially after you are established. Instead, we are going to look into what Lines of Credit (LOC) and Term Loans (TL) are and when they should be utilized.
LOCs, TLs, and factors are the most common sources for contract start-up capital and are critical to your long term growth but each is a little different and should be used at different times so lets discuss each.
PROACTIVE OPTIONS (LOCs and TLs) v. REACTIVE OPTIONS (FACTORS):
LOCs and TLs are great because they are relatively cheap and can be put in place before you win, but they tend to move slowly, so if you need cash tomorrow you are out of luck, and they are generally only available to established companies, so not good for new businesses.
Factors on the other hand are expensive, but they can get you cash FAST and they are generally available to new businesses.
So if you have time to prepare for a contract win and have been in business for a while LOCs and TLs are your friend, but if a win lands in your lap unexpectedly, or if you are too new then factors may be your only option.
LOCs and TLs
The difference between an LOC and a TL: There are a few differences, but with a loan the bank gives you money, and you pay them back over time and once it is repaid the loan is done.
An LOC is like a loan that is always available, up to a max, so you might "draw down" $10K on your LOC then pay it back a month later and then draw down another $20K a couple months after that. Basically it is a pool of money that you have a lot more flexibility in using.
How do banks decide whether to give you a LOC or TL: Basically the bank wants to see how you are managing your business finances, your personal finances, and some information about your future expenses to decide whether the amount you are asking for is reasonable.
NOTE on Lines of credit: Getting a LOC is a major milestone in a contracting companies life and will open up a lot of flexibility in how you grow. You wont be able to get one for a couple years but they are so important that I want you to talk to your bank about them early and consider their history giving LOCs to small government contractors when choosing a bank
Example of how an LOC works
Let's say it's March 14th and payroll (totaling $20,000) is due on March 15 but you only had $15K in the bank.
To cover the gap you can utilize your LOC for the final $5,000, so we make payroll and owe the bank $5,000 on the LOC
Then on the 31st your customer pays you $15,000, and you immediately payoff $3,000 of the outstanding balance on your LOC, leaving $2,000
So April 1 we are going to pay the bank interest on the outstanding $2,000 (with some LOCs you may pay a prorated share of the $5,000 you drew down for half a month)
It is okay that your LOC maintained a balance but we are going to want to pay it back as soon as possible to avoid paying interest.
When do I need to start the LOC application process? Start at least a month before you SUBMIT your proposal so you can get the bank to sign off and have them issue a letter stating that if you win you will be able to get an LOC.
Some RFPs will explicitly ask for a letter from the bank but even if they don't the government will want to know that you have the financial depth to do the contract so it behooves you to have an LOC or other access to capital ready to show them if they ask.
Term loans can be used to finance corporate set-up costs but generally you as the founder will have to take out the loan as an unsecured personal loan so be ready for an eye-popping interest rate
Typical documents you will need: Every bank is different but expect to bring:
Corporate financials from the last 2 years (if you are taking the loan in the company's name):
- Tax returns
- Balance sheet
- Income statement
- Age receivable and payable report
Certificates of insurance
12-24 months worth of projections: You must be profitable in the past and in the future!
Personal finance from the last 2 years
Collateral: The bank will ask you to post collateral to minimize the risk of you defaulting on your loan (if you default on the loan the bank takes the collateral).
Receivables as collateral: Banks may ask for your receivables as collateral--meaning any income generated goes first to paying off your LOC/loan and then the excess goes into your checking account (this can be done by changing the payments in SAM to your bank’s account info).
Assets as collateral: Because new businesses have no operating history banks are hesitant to use receivables as collateral. In this case you can use your home or another large asset as collateral
Don't be afraid to negotiate! As your active contracts evolve, keep negotiating the terms of your LOC (including limit, interest rate, and other financial covenants) so that you can adequately finance expenses as they come up with each new contract
Factoring is a bit different from the other two. An LOC and TL are generally acquired preemptively with the expectation that you will win something. Factoring is a bit different. With factoring you win a contract, do some of the work, and then "sell" your invoice to the government to the factor and they pay you right away.
Why is this helpful: The government has notoriously long payment cycles but your employees and suppliers expect to get paid right away creating a short term cash crunch and a factor helps smooth this.
What are the upsides of a factor:
- You only have to pay "interest" on the individual invoices you sell to the factor
- They can be VERY fast so if you win a contact and you didn't have time to do all your financial prep ahead of time (happens frequently at the end of the fiscal year) they can meet your needs
- Can be a great short term solution while you set-up an LOC or TL that has lower rates
What are the down sides of a factor:
Between fees and "interest" factors can be VERY expensive
Because margins are low in the federal space it is easy to "give" all your profit to the factor
Why is "Interest" in quotes: Technically factors don't charge interest, because they are not giving you a loan, however they have a fee (generally 1% of the amount you factored per month) that is assessed each month, so it acts just like interest.
Recommended providers: There are MANY factors out there but after kickig a lot of tires we recommend:
- Republic Capital Access