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When to Have a Contingency Built into a Loan
A contingency reserve in a business loan is extra money set aside in case you face unexpected costs when delivering a project, like buying additional supplies or when additional development hours are needed. These back-up funds are included to help mitigate project risks and, in some cases, may improve your chances of being approved for a small business loan.
Outside of cash flow, business credit score, and financials, a well-thought-out business plan reduces your risk as a borrower, and showing you can account for project and business success will help prove your business acumen.
Contingency reserves are different from management reserves in that management reserves are used to provide a financial buffer for unidentified risks, like a natural disaster, and contingency reserves are for risks you can predict or quantify more easily.
It may sound good to include one in your loan, but contingency reserves will increase borrowing costs as you will be paying interest on a larger principal. So, if you’re on the fence, try negotiating a clause that allows you to repay the contingency reserve portion of the loan early if it’s no longer needed as a way to reduce the principal, saving you interest costs over the remainder of the loan.
When to include a contingency reserve
A contingency reserve should be used when you are borrowing to fund a project that faces potential risks that could increase the budget. Having a reserve allows you to take quick action and solve problems before they can escalate. This could be important for construction loans where project delays might impact other phases, compounding the delay, and adding significant cost.
Common projects that may benefit from having a contingency reserve include:
- Technology development, which may see overruns and delays.
- Market uncertainty, which could cause interest rate and demand fluctuations.
- Opening a branch in a new market with different compliance and regulatory demands.
When a contingency reserve doesn’t make sense
A contingency reserve doesn’t make sense if you have completed similar projects, and you aren’t in an industry where costs can spiral through delays or complications. If a manufacturer is adding machinery to increase production of their popular product, using equipment financing, they know the risk levels and likely do not need a contingency reserve.
Other reasons for not including a contingency include:
- You have enough liquid assets to cover the potential risks.
- The risks are covered by insurance.
- You can quickly and easily secure additional funding if the project has problems.
Going back to our previous section: Suppose you’re in a situation where it does make sense to have one. What is the right amount?
Calculating the right amount for a contingency reserve
To calculate how much contingency reserve you should have, factor in your:
- Business’s financial circumstances based on average cash flow available
- The industry you operate in
- Common reserves range from 5%-10% in retail, 10%-15% in restaurants, and 10%-20% in construction.
- Supply chain disruptions
- Hiring delays alongside potential drops in revenue or an increase in interest rates
Performing this risk assessment helps you judge how much additional funding you would need to keep things running without taking on the risk of overborrowing and paying the additional interest.
The number itself can be found using a flat rate calculation to estimate total risk to the project broken down by specific budget line items and calculating the expected monetary value (EMV) of each risk, or a combination of the two.
Flat rate contingency calculation
Total project cost x Percentage risk = Contingency reserves
If you have done similar projects in the past and they generally go over budget by up to 10%, applying a flat rate percentage to the entire project cost will give you an appropriate reserve. For example, if your cost for delivering a project is going to be $100,000 (but it usually comes in at 10% over that), your reserve would be: $100,000 x 10% = $10,000.
Mixed rate contingency reserve
If you are creating a product that uses a material with volatile pricing, you may want to build in a specific risk factor for this part of the budget while applying a modest risk to the rest of the project, creating a mixed rate contingency reserve.
Break out the budgeted costs for materials and apply a higher risk level of 25%. Then attach a lower percentage of risk at 5% to the remaining budget and combine the two figures to get a total contingency reserve. Your numbers will depend on your experience and processes, but these can be good starting points.
By isolating the higher risk level to one part of the budget, you reduce the contingency reserve you need and avoid paying interest on a higher principal.
| Line item | Costs | Risk | Reserve |
| Material costs | $40,000 | 25% | $10,000 |
| Remaining project costs | $60,000 | 5% | $3,000 |
| Total reserve | $13,000 |
Expected monetary value
For more complex projects facing varying levels of risk, break each line item down by risk level to create a calculated contingency reserve. This helps you avoid overborrowing as well as not having enough reserve to deal with problems when they arise.
A large construction project may involve some uncertainty as it relates to costs for materials, labor, and transport, and each has different levels of impact so they should be considered individually to have an appropriate reserve. In addition to the risks a project faces, weighing the risk level by line item makes it easier to reduce the potential contingency reserve you’ll need.
| Line item | Costs | Risk | Reserve |
| Material costs | $40,000 | 25% | $10,000 |
| Labor costs | $35,000 | 10% | $3,500 |
| Permit costs | $5,000 | 0% | $0 |
| Transport costs | $5,000 | 5% | $250 |
| Surplus materials | -$5,000 | 5% | -$250 |
| Admin costs | $15,000 | 5% | $750 |
| Total reserve | $14,250 |
Alternatives to a contingency reserve
If you have excess cash flow and the risks aren’t immediate, allocating a portion of monthly revenue into a reserve account can play the same role as including a contingency reserve in your loan. Building this safety net prepares you for the worst without incurring interest payments, and if all goes to plan, you will have built up funds for future use.
If you opted out of a contingency reserve and an emergency happens (like a power outage for a few weeks), this isn’t enough for a management reserve, but an emergency business loan could come in handy.
A contingency reserve provides a financial cushion for uncertain costs or project risks, and including one in your business loan ensures you have the necessary funds to complete the project. Adding a reserve will increase borrowing costs, and they aren’t needed if the chance of foreseeable risks is minimal. So, they aren’t best for every business loan. If you’re ready to take a loan and are deciding if you should or should not include a contingency reserve, click here to fill out our form and one of our Funding Advisors will help you decide based on what’s best for your business.
QuickBridge does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
