Reprinted with permission from Construction Executive, a publication of Associated Builders and Contractors Services Corp. Copyright 2015. All rights reserved. This post was originally published on September 18, 2015.
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Subcontractor default is neither understated nor under-reported. Everyone in the industry is familiar with it and the consequences of the likely, yet always surprising, situation when a subcontractor defaults on a project.
Starting in 2008, the construction economy started to tank and the industry experienced a wide number of subcontractor defaults. Now that the economy is recovering, it’s natural to think that defaults will be less common. The unfortunate fact is that subcontractor default is three times more likely in this recovering period than it ever was in the economic downturn.
Therefore, it is more important than ever to review why subcontractors fail, and what everyone else should be doing about such failures.
Why Do Subcontractors Fail?
There are options for companies to mitigate the risks of subcontractor failures. Understanding why subcontractors fail can help fix the problem at the source, as opposed to focusing on too many failure symptoms.
Cash Flow. The most basic explanation for subcontractor failure is that the business runs out of cash. There are many reasons for this; most notably, subcontractors often are expected to float the project costs. They pay for all materials on terms, pay all laborers weekly, give up to 10 percent of their revenue to retainage withholdings, and then wait for 30, 45, 60 days, or longer, after fronting the cash to get paid by the general contractor or owner. These are unrealistic expectations for any company that is not flush with capital.
Lack of Access to Capital. Because subcontracting is such a risky and cash-hungry business, it’s really difficult for businesses to get capital access from traditional banking sources. This is especially true in the recovering economy, where lenders are more reluctant to fund construction investments than ever. The result is that subcontractors lack any access to affordable capital. When they are pushed to get funding, they pay higher rates, putting them into a vicious cycle of interest payments and cash needs.
Tough Work. Selling washing machines is simple. A buyer gives the seller money, and the seller gives the buyer a washing machine. The machine may have a flaw, but identifying the flaw and fixing it is pretty simple. However, in the subcontracting business, work is layered upon the work of many other parties; the work itself must meet a subjective-type approval; and there are many things that can go wrong on the jobsite that puts the subcontractor in a practical or legal crosshairs. This all feeds into the aforementioned problems, as this is yet another cause for heightened cash needs.
Three Ways to Handle Subcontractor Failure
The failure of a subcontractor can be sudden and can cause vast problems. Therefore, the question is whether anything can be done about it. Following are the top three ways to protect against subcontractor failure.
Lien Rights. Though this doesn’t apply to firms at the top of the chain (general contractors, owners and lenders), it is still the number one protection measure because of how enormously effective it is for all of the other affected parties. In fact, it is even effective for the defaulting subcontractor, as it can put it in the best position to claw its way out of a bankruptcy proceedings. Lien rights protect a company’s right to get paid for work, and more importantly, prevent companies from being placed into the back of a payment line. A subcontractor in the front of the payment line avoids cash problems, and is insulated from others defaulting on the project.
Surety Bonds. Subcontractors can obtain performance bonds and payment bonds, and it’s common for general contractors, owners and lenders to require some subcontractors to acquire these bonds. When a subcontractor has these bonds, a default is less burdensome because the surety bond will compensate the affected parties for the losses.
Prequalification. Top-of-the-chain parties often use prequalification to assess the likelihood of failure by a lower-tiered party (e.g., a subcontractor). Lower-tiered parties also can use prequalification to assess the problems that might arise by higher-tiered parties.
Everyone is affected by default and should do preliminary analysis to avoid it. Examining the ability of a subcontractor to deal with expected cash flow challenges is a necessary evil in today’s construction economy. Also, it serves everyone well to make sure the subcontractor is taking measures to protect lien rights. If not, the subcontractor is going to be in the back of the payment line, and the result is a heightened default risk.
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