Construction companies have few investible assets. Contractors are service providers. Over the years they will have acquired some depreciating assets like vehicles and equipment, but vehicles and equipment are only used to generate income and retain limited value after their useful life.
No Outside Equity Investors
Contractors are not developers. Contractors provide building services to developers. Developers leverage assets and hire contractors to add value to the asset; then sell the “leveraged-enhanced” asset to the end user for a profit. The entire transaction is asset based and therefore attracts growth capital in the form of initial equity and additional leverage through collateralized bank debt. Contractors can do neither.
No Public Equity Investment
An infinitesimal percentage of the more than a million contracting firms now operating in the U.S. are public companies. Nevertheless, the U.S. construction industry produced roughly $1.5 trillion dollars in sales last year. No other industry in the US has been able to achieve this scale without an injection of equity capital from the investing public.
Contracting companies have little “book value” that can be leveraged to finance growth. They do not produce reliable profits that might be investible, so Wall Street has trouble valuing the industry. Only a few large construction companies have gone public after many years of accumulating fixed assets, developing a high-quality brand, earning a vast network of valuable clients, producing reliable profits, and achieving a scope of work that few competitors can produce.
No Retained Earnings
Even contractors themselves understand that contracting is something they do and not necessarily an investible asset class. They provide the initial capital to get their firm up and running and usually try to re-invest as little as possible as time goes by. Most contractors consider it too risky to leave much of their earnings on their own balance sheet to invest in future work. They remove most of the retained earnings periodically to prevent them from being gobbled up in the firm’s persistent cash flow needs. This leaves even successful contractors in a constant cash flow bind. We seem to believe that one way or another we will squeeze the cash needed to complete the project out of the owners, the subs and suppliers, or our reluctant bankers. Usually we do, but if we can’t, disaster strikes.
No Reliable Source of Working Capital
To make cash flow matters worse, the somewhat twisted nature of the construction financial transaction imposes the entire burden of financing the asset improvements on the contractor’s shoulders. This, of course, is a grave misappropriation of risk. Contractors have little access to growth capital since contracting companies do not ordinarily own a lot of assets against which they might leverage working capital.
We do not sell stock to the public.
We cannot leverage the value of the contracts we are working on since banks don’t consider a service contract to have collateral value.
We cannot require the developer or the government agency who has hired our services to put up-front money to cover the cost of construction until invoices have been submitted and paid. These thirty, sixty, or even ninety-day payment delays add up to millions of dollars.
We cannot even submit dollar for dollar invoices for all expenses incurred but rather must estimate the amount of the project completed and wait patiently for payment against this often contested estimate.
Where Does That Leave Us?
Holding the bag. Burdened from the outset with more risk than we can properly handle forces us to invent mitigation techniques that shift some of the risk back on the other parties to the transaction.
Front loading invoicing at the beginning of the project. (This technique, however, comes back to bite us toward the end of the project.)
Aggressive borrowing at the bank, encouraging the bank to consider their risk if they don’t supply us with adequate capital to complete the project.
Extending supplier and subcontractor payments from 30 to 60 days, and sometimes longer, to lubricate sticky cash flow.
Attempting to price extras aggressively. (Fortunately, owners and designers have few alternatives.)
Borrowing cash flow from the next job to fund the dried up “end-of-job” cash flow from the current job.
Managing these mitigation techniques is like trying to juggle five balls at the same time. Only the most accomplished acrobats can do that successfully and sooner or later they miss one and all the balls fall to the ground.
Recognizing and Properly Assigning Risk in Advance
Next week we’ll discuss how to recognize and assign financial risk in advance to the proper party in the construction transaction. Don’t miss it.
For more information on profitable business practices, read more at: PROFIT
For a broader view of financial management, read more at: MANAGEMENT
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Please circulate this widely. It will benefit your constituents. This research is continuous and includes new information weekly as it becomes available. Thank you.
