Contract financing is a way to turn a future payment owed to your business into cash you can use now. A funding company advances you most of the value of a signed contract or an unpaid invoice, then collects the payment from your client when it comes due and takes its fees out of that payment. It’s structured as the purchase of a financial asset — your right to be paid — rather than as a traditional loan against your balance sheet, which is why businesses that couldn’t qualify for a bank line can often qualify for this.
How the Arrangement Works
Three parties sit around the table. You’re the contractor doing the work. Your client (sometimes called the obligor) is the one who will eventually pay for that work. The funder is the third party who fronts you cash against that future payment.
You start with a binding contract for goods or services. That contract, or the invoices it generates, becomes the asset you present to the funder. The funder advances you a substantial percentage of what the contract is worth. You use the cash for payroll, materials, overhead, whatever the project needs. When your client pays, the payment goes to the funder. The funder deducts its advance and fees, then sends you what’s left, called the reserve.
The mechanics of who gets underwritten are what separate this from a bank loan. A bank looks at your credit, your collateral, your balance sheet. A contract funder looks mostly at your client. If your client is a large corporation or a government agency with a solid payment record, your own financials matter less than they would to a bank. The funder is betting on the client’s willingness and ability to pay the invoice, not on your ability to service a loan out of general revenue.
The cycle can repeat with every new invoice or contract, which makes contract financing a rolling source of working capital rather than a one-shot injection. Once you’re set up with a funder, each new receivable moves through the same pipeline.
The Main Forms
Invoice Factoring
Factoring is the most common form. You’ve finished the work and sent the invoice, and now you’re waiting on net-60 or net-90 payment terms. Instead of waiting, you sell the invoice to a factoring company at a discount. The factor advances you a percentage of the face value — typically 80% to 95% — and collects directly from your client. When your client pays, the factor releases the balance to you, minus fees. Under the Uniform Commercial Code, this sale is governed by Article 9 and treats the factor as a secured party for purposes of perfecting its interest.1Legal Information Institute. UCC Article 9 – Secured Transactions
Factoring comes in two forms. With recourse, you carry the risk if your client doesn’t pay; if the invoice ages past a set window (often 60 to 120 days), you have to buy it back or swap in another eligible receivable. Non-recourse factoring shifts credit risk to the factor and costs more, though it usually covers only client insolvency, not disputes over whether your work was acceptable.
Purchase Order Financing
PO financing happens earlier in the cycle. You have a confirmed, non-cancelable purchase order but not the cash to buy the materials to fill it. The funder pays your supplier directly for the raw materials or components, so you can deliver the finished product without laying out the procurement cost yourself.
Because the funder is putting money in before the goods exist and before there’s an invoice to collect, PO financing carries performance risk on top of credit risk: you still have to turn those materials into something the customer accepts. That extra risk shows up in higher fees than factoring. Some contractors stack the two, using PO financing to fund production and then factoring the resulting invoice to bridge the gap until the customer pays.
Mobilization and Progress Payments
Mobilization payments are lump sums paid at the start of a project to cover setup costs — establishing a job site, hiring crew, acquiring specialized equipment. They’re based on the contractor’s commitment to perform, not on completed work. Progress payments are released in stages as the contractor hits defined milestones, with each release tied to verified completion of a phase. Both are common in construction, where upfront costs are heavy and the project timeline is long.
What It Costs
Contract financing is priced in fees and discount rates rather than annual interest, which makes side-by-side comparison with a bank loan harder than it should be. The total cost depends on how much risk the funder is absorbing and how long the money stays out.
The Discount Rate
The main charge is a discount rate, sometimes called the factoring fee. It’s a percentage deducted from the invoice’s face value for the initial period — usually 30 days — that the invoice remains outstanding. Rates swing widely with client credit quality, industry, and volume. High-volume arrangements with strong clients can price under 1% per 30-day period. One-off or higher-risk deals can run several percent for the same window.
Most agreements add an incremental fee for each additional period the payment stays outstanding past the initial term. This tiered structure pushes clients toward faster payment. One thing to watch: the discount rate applies to the gross invoice value, not to the advance you actually received, so the effective cost of the capital you can use is higher than the headline rate suggests. A 2% monthly fee looks modest until you annualize it and see something north of 24%. Run that math before signing.
The Reserve
The reserve is the slice of the invoice the funder holds back from your advance, typically 5% to 20%. On a $100,000 invoice with an 85% advance, $15,000 sits in reserve. That cushion protects the funder against disputes, returns, or adjustments between you and your client. When your client pays in full and the payment clears, the reserve comes back to you, minus accrued fees. It isn’t a cost by itself, but it does reduce the working capital hitting your account on day one.
Other Fees
Factoring agreements often carry ancillary charges: application fees, due diligence fees for running credit on your clients, wire fees, and minimum volume fees if you don’t factor enough invoices to meet a contractual threshold. These add up quickly. Before you sign, map every fee against the net cash you’ll actually receive. The real cost of capital is the total of all fees divided by usable money, not the headline discount rate.
What You Need to Qualify
The Client and the Contract
The contract has to be binding, with clear terms on scope, pricing, and payment schedule. The client has to have a verifiable credit profile, because the client is who the funder is really underwriting. Expect the funder to run its own due diligence on your client through commercial credit reporting services.
Anti-assignment clauses are a common snag. Many commercial contracts include language forbidding assignment of rights under the agreement. For private-sector contracts, UCC Section 9-406(d) generally makes those clauses unenforceable as to the assignment of accounts and payment rights, so a factor can still take a valid assignment of your receivable even if the contract language says otherwise.2Legal Information Institute. UCC 9-406 – Discharge of Account Debtor; Notification of Assignment Legal enforceability aside, the client may not know this, and pushing the issue can strain the relationship. Most experienced factors will flag the clause and talk through the practical implications before proceeding.
Your Own Documentation
Even though the funder is mainly underwriting your client, you still have to show you can deliver. A funder wants confidence that the payment stream will actually materialize, which means you need to demonstrate the operational capacity and expertise to finish the work.
Documentation usually includes several years of business tax returns, current financial statements, and proof of adequate insurance. For PO financing, add clear documentation from your supplier showing the cost of goods. Newer businesses face a real hurdle here: without a track record of completed contracts, qualifying can be difficult even when the client is rock-solid.
The funder may also require a security interest in your other business assets, perfected through a UCC-1 financing statement. That’s separate from its interest in the specific receivable being financed.1Legal Information Institute. UCC Article 9 – Secured Transactions
Existing Liens
Here’s where many contractors get blindsided. If you already have a business loan or line of credit backed by a blanket UCC-1 lien on all your assets (which most bank lending involves), that lien already covers your accounts receivable. UCC priority runs on a strict first-to-file rule, so your bank has the senior claim.
A factor won’t advance against receivables another creditor has a prior claim on. You’ll need the existing lender to sign a subordination agreement stepping behind the factor as to receivables specifically. That process typically takes two to four weeks, and the existing lender is under no obligation to agree. Lenders tend to be more willing when the new financing doesn’t compete with what they actually care about (say, your equipment or real estate), and less willing when both creditors want the same asset class.
A Note on Federal Contracts
If your client is a federal agency, different rules apply. The UCC’s override of anti-assignment clauses doesn’t reach federal contracts; there, the Assignment of Claims Act controls, and an anti-assignment clause in the contract itself is enforceable.3Office of the Law Revision Counsel. 31 US Code 3727 – Assignments of Claims The statute permits assignment of money due under a contract worth at least $1,000, but only if the contract doesn’t forbid it, only to a single financing institution, only for the entire unpaid amount, and only with written notice filed with the contracting official, the surety on any bond, and any disbursing official. The federal government also provides its own contract financing mechanisms directly to contractors, including customary progress payments and performance-based payments under the Federal Acquisition Regulation.4Acquisition.GOV. FAR 32.104 – Providing Contract Financing If federal work is a meaningful share of your business, treat those rules as their own project before you sign with a private funder.