Historically, construction industry participants are three times more likely to fail during an economic recovery than they are during an economic downturn.
What does this mean for construction companies that want to successfully navigate through, and grow throughout, a period of economic resurgence? In real, practical terms, it pays to be mindful of the potential missteps that can derail construction participants in a rebounding market, and use that knowledge to better position the company for growth and continued success.
Contractors should pay attention to the following for the best protection.
- While a recovering economy provides more opportunity for business, it pays to be careful regarding how much more business is accepted (at least in some circumstances).
- Understand that customers are navigating the same recovery and face the same risks, so make smart credit decisions underscored by that knowledge.
- Protect and perfect mechanics lien rights. They are very important in that they act as security in the turbulent upturn.
Keeping in mind that the financial and legal risks associated with expanding a business, and especially a construction-related business, can be exacerbated in a rebounding economy, it pays to be attentive, promote visibility and remain secure. The above tips make sense and may seem obvious, but how does one go about putting them to use in a practical sense and grow a business through a turbulent recovering economic market?
Be Aware of Financial Risks of a Rebounding Economy – and Respect Them
Why are construction companies three times more likely to fail in a recovering/growth economy than they are in a stagnant/downturn one? While this is slightly counter-intuitive, once examined it starts to make sense. The 1,000-pound gorilla in construction-related businesses is cash flow. Labor and materials are delivered on credit and the A/R reports get filled with past-due accounts. In a growth economy, there can be multiple available projects and growth opportunities, but construction industry participants can be low on cash from surviving the previous economic downturn. If the cash reserves are low, the companies may not be able to float the costs necessitated by the growth opportunities, and that spells trouble. Companies get stretched too thin, and ultimately fail. Compounding that issue are facts like:
- wary credit markets mean less access to cash;
- scaling operations quickly can cause delays; and
- due to the interconnected nature of construction and construction payment, one failure on the project can have a domino effect of triggering other defaults both up and down the contracting chain.
Fight Risk-Shifting With Fairness and Security
Parties occupying different places on the construction contracting chain have very different views on financial risk. It’s also well-known and easily understood that the parties closest to the money have a position from which they can exert leverage over the parties below. This leverage can be exerted in obvious and non-obvious ways, but it pays for construction participants to be diligent in examining contracts, waivers and other documents.
Keep the following in mind.
- Pay attention to “contingent payment provisions” within the construction contract, such as pay when paid and pay if paid clauses. Make sure it is understood which party carries the burden of nonpayment risk.
- Protect mechanics lien and bond claim rights. These are the ultimate risk insulation devices.
- Have a strong written credit and collections policy that sets forth the steps to be taken without wasted time and effort.
While risk-shifting, at least to some extent, is ubiquitous in the construction industry, there are things that can be done to mitigate any exposure. Providing visibility to all the parties higher on the contracting chain by sending preliminary notices is a good first step. While providing this visibility is fair to those parties (they don’t need to worry about the risk of a “hidden lien” if they know who is on the project), real and substantial benefits trickle down. The first is that by providing visibility, the top-of-chain parties know who needs to be paid. Perhaps more importantly, providing a preliminary notice makes sure that the parties above prioritize invoices.
Mechanics liens (or bond claims when applicable) are the end-game in protecting against possible risk shifting, and have the ability to disrupt enormous projects, or even result in the sale of the improved property to pay the amount owed. Because of this, parties that stay in a secure position (with the ability to file a valid mechanics lien) get paid faster and more often than those that don’t. Because the preliminary notice works doubly to keep the company secure and inform the upper-tier parties of its secure status, it’s incredibly effective to ensuring payment is made.
Growing a construction company in a rebounding economy can be fraught with danger and the increased possibility of failure. However, using security rights and visibility to combat the cash flow problem and mitigate the potential financial risks can protect and empower the company to realize the opportunities presented by the industry’s economic growth.