The good news about the construction economy in 2014 is that it’s expected to grow. The result of the growing economy will be new opportunities, and these new opportunities may encourage businesses to get larger.
Sometimes, businesses will even cross state lines or expand into other lines of business. There are financial and legal risks associated with expanding a business, and some of these risks are exacerbated in a rebounding economy.
1. Know and Respect the Financial Risks of a Rebounding Economy
In early 2013 (when the construction industry was excited about a potential 2013 rebound), ENR published a Viewpoints article written by Thomas Schleifer, Ph.D., titled “Beware the Recovery.” According to Schleifer’s research, construction companies are three times more likely to become insolvent and fail in a recovering economy than in a downturn economy.
Long recessions suck cash from organizations, and the companies that survive the recession are usually pretty low on cash. A recovering economy presents growth opportunities, but fast growth requires cash that the recovering organizations lack. This results in companies getting stretched too thin, and ultimately, failing. Consider some of these other factors as well:
- Credit markets are still gun shy from the recession, and there is less access to cash.
- Scaling operations quickly can cause delays (sometimes from governments). See, for example, the reported delays caused by the sudden housing surge in mid-2013.
- When contractors default, this creates a domino effect of risk and further defaults up and down the chain
2. Engage In the Financial Risk Shifting Battle
An article forecasting the challenges for construction industry CFOs and finance professionals in 2014 suggested that these positions are going to be more important than ever in the coming year for organizations since those “at the top of the contracting chain will be leveraging every opportunity to shift financial risk down.”
This is a trend widely reported within the construction industry at the end of 2013. Consider, for example, the September ENR Risk Management Summit where “views [on financial risk] differ from places on the payment flow-chart.” The October 2013 CFMA Conference presenter consensus was that “owners [are] shift[ing] more financial risk as recovery remains sluggish.”
A slowly recovering economy presents cash challenges, a quickly recovering economy presents cash challenges. In an economy that presents serious cash challenges, the faster the growth, the bigger the challenge.
A consequence of this environment is a financial risk-shifting war in the construction industry. When expanding a business, appreciate the dangers of this war, and position the company to engage, insulating the company wherever possible.
What can construction companies do to protect against financial risk?
- Watch the “contingent payment provisions” in the construction contract, such as pay-when-paid and pay-if-paid clauses, and make sure other parties carry the nonpayment risk.
- Protect mechanics lien and bond claim rights. These are the ultimate risk insulation devices.
- Have strong collection procedures that aggressively attack when a customer tries to abuse the payment process, stretching out payment terms or withholding money on a contract.
More of this is discussed in the Slideshare presentation: Navigating the Risk of a Rebounding Economy.
3. When Crossing State Lines, Beware of Legal Differences Among the States
In addition to the financial issues discussed above, expanding a business may carry significant legal exposure or challenges. This is especially true if the business will cross state lines.
Expanding across state lines presents legal challenges in three main areas:
- contract interpretations;
- mechanics lien and bond claim compliance; and
- licensing rules.
Construction contracts may be a private agreement with another party, but they are notoriously open to legal interpretations, and neighboring states frequently take opposite approaches to interpreting provisions. See this example of how neighboring states interpret contingent payment provisions differently.
As above discussed, managing the financial risk associated with a rebounding economy requires protection of mechanics lien and bond claim rights (i.e. the ultimate risk insulation devices). When working in multiple states, however, this can be a nightmare since the rules are different in every jurisdiction. Do not make the mistake of treating every state the same.
Expanding a construction business across state lines is perhaps more difficult than any other type of business. The industry is regulated (heavily) almost entirely by state laws, and state laws and rules are unique to each state. Construction contracts and lien laws are just two examples of how compliance in multiple jurisdictions can be a challenge, and licensing regulations are another example. An article that addresses these legal challenges more fully appeared in the Construction Executive’s Risk Management eNewsletter in September 2013: Use Caution Before Expanding Across State Lines.