I have been haranguing the industry for years about what is wrong with the contracting business model. Many of you agree with my discomfort but ask, “How do we change the long-held structure of the standard construction financial transaction?”
Let’s start at the beginning. I have preached the gospel of inordinate risk assumption buried in the standard construction contract for many years. It is impossible for contractors to manage the imbalance of financial risk woven into these complex long-term performance contracts.
Two Sides to Every Story
Over the years government agencies and private development firms have tightened the contract language to squeeze most of the financial risk onto the construction company’s side of the contract. In fact, most government entities open all contracts to competitive bidding and award the contract to the lowest qualified bidder. This requirement, when viewed from the government’s side of the conference table, is both reasonable and professional. It prevents favoritism, bribery, padding, and payoffs. It also insures efficiency on the part of the contractor.
The Construction Contract Is Here to Stay
So, the fixed-price, fixed-term construction contract is industry standard for most projects. “If you’re unwilling to sign such a contract you don’ get the work. There is no solution. Everyone signs the standard construction contract,” contractors have told me for years. “There is nothing we can do about it.”
This, unfortunately, is true. Most government agencies and private developers prefer to contract for an agreed upon price with final payment upon delivery. They will never back down from these transaction principles.
Maybe We’re Missing the Point
The business principle we are discussing in this series of blogs is how do we change some long-held beliefs leading to standard industry practices that burdens contractors with 90% of the financial risk? It is clear that we will not be changing the standard industry contract any time soon. So, is there another approach to mitigating contractors’ financial risk burden?
It is clearly unacceptable for either counterparty to a financial transaction to assume all the risk. So, what are we missing in the details of these standard contracts? Where has the industry gone wrong?
We’re Not Bankers
It is not the structure of the construction contract that we must change. It is the contractor’s role in executing the transaction.
- We are not bankers.
- We lack the capacity to finance $10, $30, and $60 million projects that take years to complete.
- We should not be forced to perform the function of banker for free.
- We should begin to negotiate for a substantial deposit at the start-up phase.
- We need to encourage the banking industry to adjust their construction underwriting standards.
Let Bankers Be Bankers
- Contractors must change the expectations of project owners going forward by requiring a substantial deposit before work begins. This simple adjustment to the contractor’s role in the construction financial transaction removes the working capital burden from the contractor’s shoulders and places it squarely on the shoulders of the project owner where it belongs.
- Bankers lending to the construction industry should be encouraged to reevaluate their working capital underwriting standards by basing borrowing capacity not only on the net worth of the contractor but also on the credit worthiness of the project owner. It is the owner’s ability to pay, enhanced by the bonding guaranteeing project completion, that determines the probability of the bank getting repaid. This credit factor should be reworked into the construction company’s borrowing capacity to rebalance the considerable risk in the construction financial transaction.
Working Together
It is not the ability of contractors to complete projects on time and on budget that eradicates reasonable profit margins, but rather the hidden cost and risk of supplying the substantial working capital necessary to complete long-term projects without an adequate source of capital.
This is where contractors can begin to change industry beliefs regarding risk assumption at the contracting stage of the construction financial transaction. Trade associations and other “like minded” industry groups need to begin to band together and insist on fair treatment from government agencies and private developers alike. We cannot continue to bear the cost of borrowing millions of dollars without the ability to pass the cost on to the customer.
Contractors are neither the banker nor the ultimate borrower in the construction transaction. We must stop accepting either role without recognizing the risk and the considerable cost. This is where change begins.
For more information on construction contracts, read more at: CONTRACTS
For a broader view of financial risk, read more at: RISK
To receive the free weekly Construction Messages, ask questions, or make comments contact me at research@simplarfoundation.org.
Please circulate this widely. It will benefit your constituents. This research is continuous and includes new information weekly as it becomes available. Thank you.
