Financial risk and construction goes hand-in-hand, and the further away a company is from the project developer, the more risk it shoulders. The scope of financial risk on a construction project is a huge topic contemplating under-funded or underbid projects, contractor default problems, misappropriation of project funds and more. Following are five ways companies can reduce or manage these financial risks.
1. Lean on Lien Rights
The mechanics lien remedy was invented for the explicit purpose of protecting contractors and suppliers against all financial risk on a project. In theory, if mechanics lien rights are properly used, those furnishing labor or material to a construction project could be as secure against non-payment as a bank. The question, therefore, is why wouldn’t every company in the world use these rights?
In reality, the mechanics lien remedy is relied upon by a lot of companies. It is common for large successful enterprise organizations to protect their lien rights on absolutely every project. (See: Justify Sending Preliminary Notice on Every Project)
These rights sometimes get a sour reputation in the industry causing contractors and suppliers to fear the remedy. The fear is misplaced, however, as lien protection and compliance is a fact of business in the industry. Savvy companies understand this, and they lean on their mechanics lien rights to insulate them from financial risk.
2. Contract and Credit Agreements
All financial risk roads lead back to the construction contract and/or the credit application. When a company steps foot onto a construction project to begin furnishing, its fate has usually already been sealed by what choices have been made during the contracting stage of the relationship.
Formal construction contracts are a battlefield of risk shifting, whereby the property owner and general contractors insert provisions and language to shift the financial risk of the project onto unsuspecting subcontractors and suppliers. And further, those suppliers who issue trade credit without getting a quality credit agreement with the customer are swimming with sharks.
3. Credit Checks and Monitoring
Anyone furnishing labor or materials to a construction project is furnishing on credit. Suppliers typically call this “trade credit,” and the parlance does not carry over to contractors and subcontractors. However, it should. Contractors and subcontractors, like suppliers, furnish their labor and materials to the property developers and then wait for payment. Pay applications are always seeking compensation for work completed.
Regardless of role, the construction industry runs on credit, and because of this, it is critical to have strong credit practices. Check a customer’s credit at the beginning of the relationship, and then monitor it throughout. It’s very important that the customer have the ability to pay. It’s even more important that a company knows about its customer’s ability.
4. Joint Check Agreements
Joint check agreements are just one example of “credit gap” tools available to those in the construction industry. A credit gap exists when the customer is without the means (or without the formal credit) to justify the company’s risk in furnishing or continue to furnish to that customer. Companies can fill the “gap” between what they are willing to do and the customer’s ability with a credit gap tool like the joint check agreement.
A joint check agreement is a tool frequently used in the construction industry for these purposes, which obligates some third parties (usually the general contractor or property owner) to pay the company directly or with a joint check to the company and its customer. The company skips over the customer and relies on the credit of some other, more stable company. Beware, however, of dangerous joint check mistakes. Other credit gap tools include the personal guaranty, letter of credit, and UCC filing.
This final risk reduction method is not only the easiest and cheapest to employ, but it is also the most important. Consistency in efforts will breed consistency in results, and unfortunately, accounts sometimes go unpaid simply because a company doesn’t have a consistent commitment to a method of signing new customers and following up with them for payment–or, worse yet, no method of doing so.