Financing Alternatives for Government Contractors©

When Significant Capital Needs Precede Customer Payments on Government Contracts
-by Richard Lewis, Financial Engineering Counselors, Ltd.

The Good News: Your Company has landed a new Government contract, one that will result in a significant increase in revenues.

The Challenge: In order to fulfill this contract, you must commit to additional people (payroll), training, materials, and related costs. This commitment must be made in advance of receiving payments from your customer (the US Government). Unfortunately, the amount of capital needed to cover your commitments exceeds the balance available on your existing line of credit or your credit card. It also exceeds the amount of cash that could be made available by delaying payments to selected vendors. The nature of this contract might justify issuing new equity or debt, but raising capital generally is an expensive, complex task that ultimately may take too long to meet your short-term contract specific capital requirements.

“While poor management is cited most frequently as the reason businesses fail, inadequate or ill-timed financing is a close second. Whether you are starting a business or expanding one, sufficient ready capital is essential. However, it is not enough to simply have sufficient financing; knowledge and planning are required to manage it well. These qualities ensure that entrepreneurs avoid common mistakes like securing the wrong type of financing, miscalculating the amount required, or underestimating the cost of borrowing money.” (Small Business Finance)

Solution – Planning!:

In order to minimize the risk of your company having to scramble to raise enough capital to ramp up for future major contracts, your internal business development forecasting process should identify and signal situations early to senior management. This will allow for a pro-active review of any significant operational, personnel, and financial impacts. Specific terms may be negotiated into the customer’s agreement to dampen these impacts. Such terms may include extended delivery dates, partial payment upon order placement, or progress payments based upon specific performance criteria.

Existing Bank or Lender – If your company has an existing line of credit or borrowing arrangement with a bank or other lender, try to negotiate an increase with them. A responsive lender may provide all of the short-term capital needed until the Government agency begins payment. You should be aware that trade-offs of a significantly higher level of credit might involve committing to a new long term deal, additional loan covenants, greater reporting requirements, and/or higher interest rates. In addition, your credit agreement may constrain your ability to take on other types of debt or lease obligations. In any event, it is best to discuss the situation as far in advance as possible and have a full financing/business plan and presentation available. Remember, LENDERS HATE SURPRISES.

If your company does not have an accommodating lender, the following alternatives should be considered:

Factoring – This is the sale of your invoices, accounts receivable, to a bank or finance company (the “Factor”), as opposed to using them as borrowing collateral. The Factor will advance a percentage, usually between 75% and 90%, of the invoice amount to the customer; the balance is refundable upon receipt of payment, less interest and transaction costs. Some Factors may also provide weekly or mid-month, funding of unbilled accounts receivable, mobilization financing for new contracts, and/or “term loans” for multi-year contracts. The Factor will, through the Federal Assignment of Claims provisions, notify the Federal Government agency customer that the invoice has been financed and is payable directly to them. There are several advantages to factoring; much of the A/R bookkeeping, customer credit worthiness, collections, and credit risk become a shared responsibility with the Factor, and the initial approval process can usually be a matter of days.

In addition, because the primary credit criteria is based on your government customer, the federal, state, or municipality, a Factor will generally provide financing for start-ups, 8a, minority, service disabled veteran, woman, Native American owned contractors, or other companies that may have a questionable credit history. Although sometimes more costly, it is a viable alternative to traditional bank financing because of its increased flexibility. In addition, many Factors will provide a “financial support” letter, submitted with the proposal, to the Government agency insuring that their institution’s financial strength is behind the client.

Contract Financing/Purchase Order Financing – You may be able to negotiate financing based upon your Federal Government customer Purchase Order(s). Some lenders provide Purchase Order financing based upon the credit worthiness of your customer (in this case the US Federal Government). PO financing is easiest when your products or services are well established. If your products are new, services are non-standard and/or unproven, PO financing is more difficult to obtain. The effectiveness of contract/PO financing in a pre-revenue ramp up situation will be determined by how soon your company can invoice the customer.

Commercial Financing-Asset Based Lending – This is a common type of financing provided by most banks and commercial financial companies. The primary asset used in this type of lending is your company’s accounts receivable, although inventory, fixed assets, and in some instances, intellectual properties may be used to collateralize additional long term financing requirements. With asset based lending your, as well as your customers’ credit worthiness will determine the percentage of the receivables that will be advanced, usually between 75% and 90%. Inventory and fixed assets advance rates are most often significantly lower because these are less liquid assets. This financing is almost always provided on a revolving or an on-going basis, thus the term “revolving credit.”

Leasing and/or Sale and Leaseback – These financing alternatives can be used to generate capital from fixed assets that are to be obtained or currently owned by your company, such as computers, equipment, furniture and fixtures, vehicles, and real estate. Banks, financing companies, dealers, and manufacturers provide these more specialized services. Your company’s credit standing and the quality of the assets involved will determine the amount of cash that can be raised and the terms under which it is provided. The specifics of the agreement will determine if these leases have to be reported on your company’s balance sheet or if they can be treated as “off balance sheet” items.

SBA Loan – The SBA offers numerous loan programs to assist small businesses. It is important to note, however, that the SBA is primarily a guarantor of loans made by private and other institutions.

The Basic 7(a) Loan Guaranty serves as the SBA’s primary business loan program to help qualified small businesses obtain financing when they might not be eligible for business loans through normal lending channels. It is also the agency’s most flexible business loan program, since financing under this program can be guaranteed for a variety of general business purposes. Loan proceeds can be used for most sound business purposes including working capital, machinery and equipment, furniture and fixtures, land and building (including purchase, renovation and new construction), leasehold improvements, and debt refinancing (under special conditions). Loan maturity is up to 10 years for working capital and generally up to 25 years for fixed assets. http://www.sba.gov/financing/sbaloan/snapshot.html.

SBIR and Grants: SBIR (Small Business Innovation Research) is a federal government program administered by 10 federal agencies for the purpose of helping to provide early-stage Research and Development funding to small technology companies (or individual entrepreneurs who form a company). Solicitations are released periodically from each of the agencies and present technical topics of R&D, which the agency is interested in funding. Companies are invited to compete for funding by submitting proposals answering the technical topic needs of the agency’s solicitation. Each agency has various needs and flavors of the SBIR program and you can learn more about them by visiting their sites. Here are the addresses for the SBA, DOD, and NIH: http://www.sba.gov/sbir/, http://www.acq.osd.mil/sadbu/sbir/, http://grants.nih.gov/grants/funding/sbir.htm.

None of the alternatives mentioned above are mutually exclusive. In many cases, combinations can be very effective. However, there are significant legal and operational differences in these financing arrangements. The terms of some borrowing agreements may limit your ability to take on additional debt and they should be entered into only as part of a coherent financing strategy. Do not be alarmed when the lender asks for your personal guaranty. Personal guarantees are virtually standard for all but the most credit worthy and/or public companies.

For questions or additional information, please do not hesitate to contact Richard Lewis at 703.992.8988, email [email protected], www.fecltd.net.