Risk can cause sleepless nights unless it is managed through process and accountability. Meeting strategic objectives does not happen through osmosis.
A good contractor is a good risk manager. A great contractor is a great risk manager. Commercial construction requires the management of many different types of risk, from life safety to legal to financial. How does a contractor assess the amount of risk a construction business can, or should take on and what are ways to manage and mitigate that risk?
What is considered a reasonable amount of risk?
A reasonable amount of risk can be defined as what a company is willing to financially lose. Questions to ask are:
- Is the company cash rich?
- How much cash would it take to recover from nonpayment on a construction project that wasn’t secured?
- What does the company’s line of credit look like?
- Does the company have a solid relationship with a bank?
- Is there a backlog of sales?
- If a catastrophic event occurs, whether economic or climate-related, how long can the business survive without going bankrupt?
- Are payments secured through personal guarantees, preliminary notices, liens, bond claims and UCCs?
The best way of analyzing the financial health of a business as it relates to risk is by looking at the balance sheet to assess financial strength. Look at topline growth and leverage financial strength so the company can take on more risk. This is done only by setting policies that serve the needs of the company. A company should never be desperate for cash flow, otherwise it is taking on too much risk. Making decisions based on a hope or a promise leads to despair. Instead, set policies that serve the company’s needs by securing debt.
Secure debt and reduce risk in four simple steps
1. Credit Check
On the bell curve of risk, beware of over-leveraging the company by offering high-risk customers more credit without securing payment through preliminary notices, liens, claims on bond and personal guarantees. Don’t let sales or credit managers make emotional decisions. Rather, make sound financial choices that keep both the company and the customer out of trouble.
A written contract is the rule book for resolving any disputes, so take care to ensure that the rules favor the company. Four must-have contract provisions include:
- a clear recitation of the scope of work and materials to be provided (don’t over promise here);
- a list of exclusions, exceptions and assumptions upon which the agreement and the scope of work are premised, which gives some wiggle room in case the job does not go as smoothly as planned;
- the right to recover interest on all unpaid balances; and
- the right to recover collection costs and legal fees if there is a dispute or if the company needs to sue to collect. And even though this is stating the obvious, make sure the agreement is in writing and signed by an authorized representative of the customer.
3. Securing interest
Securing interest in a property through preliminary notices, liens and claims on bond is an integral part of the entire accounts receivable process. Securing rights to lien or to place a claim against the bond provides leverage on receiving payment by securing equity interest in the property. As a contractor, lien rights are critical to increasing the likelihood of payment. As a subcontractor, sub-subcontractor or supplier, lien rights can do double duty. Specifically, a lien can allow for a direct claim against the owner while at the same time, avoiding any thorny contract provisions, such as pay-if-paid, made with the customer, be it the contractor or subcontractor. Time frame requirements vary by state. Establish policies, processes and accountabilities that will help collect money faster, more efficiently and with reduced risk. By developing this process, a company becomes proactive instead of reactive. A company can develop a step-by-step process:
- send a preliminary notice as soon as work begins on the project;
- if not paid within 45 days, make a kind collections call;
- if not paid in 60 days, send a demand letter requesting payment or possibly threatening to lien the property (or make a claim against the bond, if applicable);
- if still not paid, lien the property at day 80; and
- if not paid after 30 days of recording the lien, start the foreclosure process (between each step more collection calls, statements and meetings can apply).
Construction liens and bond claims are a powerful collection tool in a contractor’s arsenal. The question shouldn’t be whether a contractor is close to losing lien rights because the clock is ticking; rather it should be a statement: this is the company’s process and this is what must be done in order to collect the money to reduce the company’s exposure. Even billion-dollar companies fail to monitor deadlines and make emotional decisions based on relationships rather than on statutory requirements.
4. Remember to be human
People and companies endure difficult times. This is where a corporate culture of kindness and understanding comes into place. Determining company strategic objectives and implementing a healthy process for credit and collections will mitigate risk and lead to a prosperous 2017.