The two major risk factors built into contracting:
1) Chronic under-capitalization 2) Highly complex transaction
Chronic Under Capitalization
Every contractor I have worked with over these past 40 years has been plagued by cash flow problems at one time or another. As we discussed last week, the contracting transaction stacks the cash flow deck against the contractor.
- Construction concerns that are profitable even over many years rarely retain enough earnings to accumulate abundant working capital.
- Most construction firms are closely held or family-owned and are reluctant to sell any part of the business to raise growth capital which all other industrial concerns do almost routinely.
- Since ongoing business for contractors is by definition new business, earnings are rarely stabilized and often unpredictable. Even successful firms that may want to tap public markets for growth capital are unattractive to investors because of the erratic and unpredictable earnings projections from job to job.
- Since ongoing business in construction is by definition new business, cash flow is rarely stabilized since cash flow requirements differ widely for each project.
- The banking community has never valued construction accounts receivable. They discount the total amount in establishing a contractor’s working capital line of credit. Banks base working capital lines primarily on the tangible net worth of the contracting concern and its owners. This is a complete capital mismatch. The net worth of a construction firm has nothing to do with the amount of working capital that will be required to see a particular project through to completion.
- In short, the construction enterprise not only has to build the projects, but also must finance them without reliable access to capital.
Highly Complex Transaction
Contractors provide construction services to government agencies and private parties. We are service providers. Period. How did we let the contracting transaction become so complicated and one sided that the signing of a construction contract has become an act of financial hara-kiri?
Let’s look at the typical purchase and sale transaction that all other industries execute routinely.
- Conceive, design, and manufacture a product that services an identifiable market.
- Total the costs of manufacture, add a reasonable profit, set the selling price.
- Complete the sale via a financial transaction (cash or credit).
- Collect payment from customer or financial intermediary.
- Reinvest part of the payment in ongoing manufacturing to meet demand and pocket the profit. The end.
Now let’s look at the typical construction contracting purchase and sale transaction.
- Client conceives and designs the product they desire.
- Client conducts a “Dutch auction” asking firms to provide the “lowest bid” for their services forcing contractors to estimate how much of their profit and cost to discount to arrive at the lowest price for their services to secure the contract.
- Client requires contractor to sign a legally binding performance contract that the project will be completed within the “projected” time frame and for the cost that was, at this point, only a “low ball” estimate.
- Client provides no “down payment” requiring the contractor to finance all costs until the “conditional” progress payment is due. In other words, the contractor is required to not only provide construction services but also banking services throughout the entire term of the project. (This runs into millions of dollars.)
- Client requires contractor to insure through bonding that the construction services provided will be completed exactly as estimated.
- And on top of that the client retains an additional part of the cost (often 10%) as a guarantee that the contractor will perform as agreed.
What If Retailers Did That?
Imagine a retailer accepted credit card payment from every customer but the bank credited the retailer’s account with only a small portion of the purchase price 30 or 60 days or more later.
The retailer would never accumulate enough money to replace their inventory and would soon be out of merchandise. If the retailer financed replacement inventory out of their own pocket, the more they sold the more of their own money it would take to replace the merchandise. I think we can all see where this is going.
The first step in mitigating risk is to recognize the risk clearly. That’s why I keep pounding away at these two indigenous risk factors: 1. Chronic under-capitalization and 2. Highly complex transaction.
Once we clearly see the field we’re playing on, we can conceive a game plan that fits the circumstances. Tune in next week for more of this pre-game show.
For a deeper look into risk management, read more here: RISK
For a broader view into business failure, read more here: FAILURE
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