Recent history has shown that construction firms are not too big to fail even though they may have annual revenues ranging from hundreds of millions to several billions of dollars.
While there are bonding safeguards to protect project owners and others when a contractor fails, there are no such safeguards for the contractors themselves. Such an event affects not only the employees and shareholders of the firm that fails, but also the industry as a whole. During the past few decades, there have been dozens of large contractors that, after many years of growth and apparent prosperity, experienced notable financial disasters, resulting in bankruptcy or a reincarnation of the business in a much different form.
Why Do Successful Contractors Self-Destruct?
The industry has regularly witnessed smart leaders making what appear to be the same fatal mistakes others have made before them. Frequently cited mistakes are:
- Unrealistic growth, over expansion, unfamiliar new markets or entry into new types of construction
- Volume obsession
- Unrealistic promises, bad contracts or poor project selection
- Insufficient capital or profits
- Lack of business knowledge, poor financial management, poor sales skills or inadequate marketing
- Poor leadership or poor leadership transfer
- Project losses or poor field performance
- Owner court battles or owner bankruptcy
- Industry or economic weakness
- Banking and surety changes
While helpful, this list of mistakes provides insufficient clarity regarding the causal roots of failure. In order for firms to have stronger preventive guidance, leaders need to understand the causes behind the causes. There are four major categories.
General Economic Conditions
Specific economic forces affect contractors through many paths, including bonding issues, demographics, government policy, tax law, consumer confidence and even material shortages. For example, contractors may blame their financial disaster on a lack of available work due to a suppression of construction plans that is caused by an increase in interest rates. The fact that not all contractors fail during difficult economic times indicates that there are other, more relevant causes. In fact, many seasoned industry executives emphatically reject the notion that luck or other extraneous forces are responsible for a company’s decline. Nonetheless, research indicates that these external factors quicken the pace of demise for companies that suffer in other areas of concern.
The Nature of the Construction Industry
Many of the characteristics that are unique to the construction industry are key contributors to a contractors’ financial difficulties.
- Leverage. Leveraging working capital or leveraging equity is what is meant by “leverage” in the construction industry. High leverage for contractors typically refers to the amount of revenue pushed through the pipeline compared to the underlying equity base or level of working capital. Contractors, especially in the building market, can do a large amount of business with a little bit of equity.
- Workforce issues. The construction industry is a people business, and without the right people in the right places, contractors are bound to get into trouble. Where are these people going to come from, and where will a construction firm find technically qualified people to do the work in the pipeline now and in the future?
- The cyclical nature of the industry. Construction activity rises and falls faster than the overall economy. Such fluctuations lead to being over-committed or scrambling for work to keep people busy. Both can lead to problems.
- The hard-bid process. The way work is procured in a large part of the construction industry is different from the way most businesses work. The owner wants a building and wants to know exactly how much it is going to cost before the project is built. Increasing complexity of projects, fluctuating materials costs and labor concerns all conspire to make this a dangerous get-work practice for contractors. While the predominance of this method is changing with new delivery methods, it is easy to see how contractors still get into trouble here.
- Project timing. Dictated by owners’ schedules, contractors have little control over project start dates. Sometimes project opportunities become available at the same time, leading to over-commitment of company resources. In other cases, project start dates slip, creating staffing and financing challenges for the contractor. Backlogs can fluctuate widely. A related issue is long project durations, which can result in project impacts due to material, labor, weather and related issues.
- Derived demand. Most businesses think they have the ability to affect the demand for their service or product. If a company wants more business, then it conducts more marketing to create the demand for its product or service. On the other hand, contractors are always responding to opportunities. Ninety-nine percent of the work done in the construction industry comes from contractors responding to available work. Therefore, contractors are at the mercy of the work that comes their way.
- The hyper-competitive construction industry. Construction is an easy business to get into; low barriers to entry and price-driven competition lead to a very competitive industry. In addition, when every project is unique, contractors don’t get to practice. The learning curve can be expensive and not all learning is portable to the next project.
Culture and Systems of the Organization
Corporate culture issues have gained recognition in recent years as being more important than historically thought. This area is especially notable when clashes in corporate culture are cited as leading to a company’s end. Ethical and moral issues are some of the more serious areas of corporate culture failures, but a company’s culture also affects decisions about its strategy and hiring needs. The strength of the company’s culture dictates not only its ability to hold firm on the practices needed to maintain a financially disciplined organization, but also its capacity to change and meet the evolution of the market and the competition.
- Financial discipline. Some contractors are not good business people. They are good builders, but they don’t give the financial side of the business the attention it deserves. Lack of financial discipline generally means the business is not being managed like a real business. For example, at some firms the financial people aren’t involved in decision-making; instead, they are relegated to bookkeeper status with the thinking that the only real work of a construction business is construction.
In addition, companies that do not maintain adequate capital reserves are running on the razor’s edge. One misstep can cause them to fall into a cycle of failure. This management aspect is a critical area that affects the long-term sustainability of a contractor. It is often sabotaged by other corporate and personal demands, leading to the company’s demise.
- Decision-making. Many contractors do not have a well-defined process for making go/no-go decisions when deciding whether to take on a project. In a highly competitive business, one bad project can mean an unprofitable year, or worse.
- Succession planning. Ensuring that a strong leader is replaced with another strong leader when the time is right assures the continuity of the business and future growth. This does not happen often enough in the construction industry.
- Innovation. There is often a sense that construction is a business that never changes. If that was ever true, it isn’t anymore. Innovation is required to win work and to build it profitably.
- Strategic planning. Many construction companies do strategic planning, but don’t have very good strategies. They tend to be so caught up in the process that they forget that their task is really to determine what kind of company they are and where the company should be headed. Instead, their “strategic” planning becomes an operational fix-it list.
The Mind of the Contractor
Most contractors are by nature driven to grow their business. They want to build the biggest job or perform the most volume. They readily buy into the “if you’re not growing, you’re dying” mentality. If the firm is public, the market expects it to grow. Part of that expectation is the belief that profits will grow along with revenues. In construction, this result is often not the case.
Additionally, contractors often are rapid decision-makers who sometimes act too quickly when a more deliberate approach is needed. Most leaders in the construction industry came from the operations side of the business. While this is a critical background for a construction executive, the CEO’s job is to run the business, not the projects. A project focus to the business can lead to a feast or famine mentality. Getting the next project and building the backlog seems to overshadow all other considerations — frequently leading to taking the wrong job for the wrong reasons.
In addition, construction is a high-risk industry, so it is not surprising that those who venture into this business are numb to its inherent risks. Many people outside the industry consider it crazy that contractors would assume such risk compared to the low margins gained. Yet, the people running construction companies don’t see it that way. Instead, they sign personally for bank loans and bond guarantees thinking it is “no big deal.” They believe they can control the risks. They have strong egos and a can-do attitude. This supreme confidence can be a great characteristic for a contractor, but it also can lead to the downfall of the business.
These four major causes are a result of some critical root causes. A deeper look at why contractors fail, including an examination of the chain reaction failure model in action, is in FMI’s white paper, Why Contractors Fail: A Causal Analysis of Large Contractor Bankruptcies.