The construction industry has traditionally been an area where factoring firms have been wary to tread. The amounts of money to factor the invoices are large and building projects are fraught with potential hazards.
However, recently financiers have found ways to minimise risk. As a result, 5% of UK Invoice Finance and Asset Based Lending (IFABL) members are now involved in construction finance. This has come through a better understanding of how the construction business works.
The Golden Rule
The golden rule for invoice financiers is that “each invoice must be legally enforceable debt in its own right”. Thus, a factoring company will not say ‘yes’ or ‘no’ to a request to factor invoices for the construction of a building. Instead, they will ask to see each invoice involved in the construction and look at the merits of each invoice separately, to see if it pertains to “legally enforceable debt”. In other words, legal proceedings can be initiated if a particular invoice is not paid.
Construction is a complex business involving many sub-contractors. The following are considered the safer areas of construction to provide factoring services for:
- Supply and delivery of materials as long as they are not part of a larger contract.
- One-off providers such as toilet fittings or kitchen fittings as long as they are not part of a larger contract
- Completed work as long as it is not subject to a retention of funds until the client approves of the work.
- Non-contractual and temporary manpower providing it is not subject to taxation through the Construction Industry Scheme (CIS).
As you can see, all the invoices generated in the above areas are discreet. Their payment is not subject to the completion of the entire construction, and they do not fall under the legal auspices of the CIS tax regime.
Where Factoring Becomes Problematic
Here are some guidelines that are used in invoice finance for the construction industry. It highlights aspects of construction that invoice financiers are reluctant to get involved with:
- Stage payments.
A building is built in stages. Often laying foundations is the first stage, building the shell another, and completing the roof another. The client and the construction company agree on the stages before a contract is signed. Payment for the construction is broken down into a series of smaller payments each dependent on the completion of a stage.
The problem with staged payments is that the contractor might go bust. The insolvent construction company may demand payment for the completion of a stage. The client will most likely refuse to pay and will pursue a counter claim in the courts that the contract for the construction was not completed.
- Retentions
In the contract for a building there is usually a retention clause. This involves the client holding back 5% of the total cost. This money is withheld to make the builder fix any problems with the completed project.
The client releases this sum last. If the contractor goes bankrupt before the building is completed, the client will not make this final payment.
- Sub-contractors
There will be the larger contract between the client and the construction company. A factoring firm can scrutinise this agreement to judge if an invoice payment is legally enforceable. However, agreements between the construction company and sub-contractors will be subject to separate contracts. There could be tensions between payment promised to a sub-contractor and the main contract between the client and the main contractor.
- CIS regulations
The Construction Industry Scheme sets out the taxation regime for work. Work can be taxed at 20% or 30%. Thus, when looking at factoring an invoice it must be remembered that at least 20% of the money belongs to the government.
Now that we have looked at the invoices which are easy to factor and the difficulties with factoring payments for such things as staged payments, it is possible to look at how factoring firms have innovated to deal with these problems.
Here are some guidelines that are used in invoice finance for the construction industry:
- Work is not paid for until it is signed off. Until the client accepts that the work has been done and has agreed to pay for that work, invoice finance is unavailable. Specialist divisions have been set up by factoring companies involved in construction to monitor building and check the details of work plans to make sure the promised work is completed and to an acceptable standard.
- Gain a full grasp of the clients’ business. Factoring firms check if a client is under the CIS and if so, what their tax status is. Moreover, they will read the fine print of building contracts to see if the work is subject to retentions.
- Setting the appropriate advance rate. This refers to the percentage of an invoice that is paid immediately under a factoring agreement. Building is complex and there are many things that can push up prices, delay work and cause arguments. The advance rate can be adjusted to try and take into account the inherent risk in construction.
- Since invoice payments in construction are subject to such things as retentions and tax, the sales ledger has to be managed carefully. This ensures the collections process and the allocations are done correctly, and are reviewed regularly.
In Summary
Once you look in detail at the complexity of the construction sector, it is easy to understand why traditionally factoring companies have stayed clear. However, it is worth noting that certain aspects of construction are lower risk, such as paying out on an invoice to supply kitchen materials.
In the case of more problematic invoices to factor, invoice financiers have implemented schemes to minimise risk of non-payment such as employing specialist divisions to monitor building work. In construction, the devil really is in the detail.
