Small Business Financing for Government Contracts
By Jon Anselma, Managing Partner, Paragon Financial Group, Inc.
In today’s economic environment, it is difficult for small businesses to obtain traditional bank financing. Especially when you’re a growing company. Imagine having the financial capability to bid on large government contracts. With the proper financing, you can leverage a small amount of capital into fulfilling large government contracts.
There are numerous government contracts awarded for all different types of products and services. A common scenario is the government is seeking goods such as light bulbs. A small business can’t compete against the big manufacturers such as Sylvania, however, often times the government is seeking to purchase from a small business in what is known as a “set aside” contract. Let’s assume that the contract is for 10,000 light bulbs. You’ve done your research and know you can buy them from Sylvania (for example only) for $75,000 and put in your contract bid for $100,000. You get awarded the contract and high-five yourself for the profit you will be making. Unfortunately, you find out that Sylvania won’t give you extended payment terms and wants to be prepaid before shipping the product. As a small business, you don’t have $75,000 for the prepayment and risk losing the contract. What’s the solution?
There is what’s called Purchase Order Financing and also Factoring. Purchase order financing provides monies or guarantees in order to obtain product, and factoring provides money immediately upon fulfilling the order, based on the invoice to the government that will be paid 30 days later. In the above scenario, there are a few ways to finance the transaction depending on the manufacturer/supplier’s appetite. Goods must always be finished and presold with purchase order financing and delivered directly from your supplier to your customer.
A finance company with excellent credit can guarantee your supplier they will get paid. There are three common types of guarantees which are applicable only for goods that are drop shipped directly from the supplier to your customer or sorted/repackaged in a public warehouse:
- Finance company and supplier sign an agreement providing for payment to be made by finance company on your behalf when the goods are ready to be shipped.
- Finance company guarantees payment to the supplier upon shipment to or receipt of goods to your customer.
- Finance company guarantees to send the supplier the funds generated from the factoring of the invoices related to that order. For example, the government receives the light bulbs, invoices are factored, and proceeds sent to supplier. Any remaining factoring proceeds are sent to you.
In each scenario, the invoice generated from the sale and delivery of the light bulbs must be factored. By factoring the invoice, the finance company pays itself back for advancing funds to Sylvania. When the invoice is paid 30 days later (depending on the payment terms), that payment which has been assigned, will be sent directly to the factor. A factoring company typically advances 80% of the invoice amount. In this scenario, the invoice to the government is $100,000. Therefore, there is up to $80,000 available to finance the purchase order to Sylvania. If the cost is higher than the 80% advance, you would have to make up the difference. However, in this Sylvania scenario, you would actually be able to fulfill the whole contract without any money out of pocket. Once the invoice is paid, the balance of the 80% advance, called the reserve, is disbursed to you minus a small fee.
Many government agencies want what is called a Financial Capabilities Letter advising them of your financial capability or backing. As a small business, this can be difficult, however, when you are the client of a knowledgeable financing company, they can provide you a financial capabilities letter which reflects the credit facility you have with them, often in high dollar amounts, which will make you stand out from your competitors and assure them of your ability to fulfill the contracts.
The above scenario is one of many and there are numerous ways to tailor a financing program to meet your needs.