It was a sad day in West Michigan in July 2014 when the President of Lamar Construction announced they were closing, bankrupt after being in business since 1938. The bank had canceled their line of credit.
According to its bankruptcy petition, Lamar owed creditors $37.7 million while holding assets of $24.8 million. The company had 280 employees in three states who lost their jobs that day without notice. Both of the owners were forced to declare personal bankruptcy. On the surface it appeared they were doing everything right, so what went so wrong? Why do contractors fail?
According to research by a leading consulting firm to the construction industry, FMI, there are approximately 200 potential factors that can lead to contractor failure. When FMI dove deeper behind those factors, they concluded that no single factor would signal the potential failure, that it was a combination of factors that interacted, causing company performance to aim toward inevitable bankruptcy. FMI pointed to four key areas that affect overall company performance that can lead to loss of financial capacity that spirals into bankruptcy.
- General Economic Conditions. Often construction company failure is blamed on economic conditions and lack of available work, but the fact that not all companies fail indicates there may be other causes at play as well.
- Nature of the Construction Industry. Construction is a high leverage, hyper-competitive business that needs to deal with industry cycles, hard-bid process and a shortage of laborers.
- Culture and Systems of the Organization. Lack of financial discipline when financial people aren’t involved in decision making but are simply glorified bookkeepers.
- The Mind of the Contractor. Construction is a high-risk business that attracts people who can make decisions quickly, push for growth, are often numb to risk and have huge egos. They want to win.
When these factors–general economic conditions, nature of the industry, culture and systems and mindset of the contractor–create poor performance, this leads to loss of financial capacity and ultimately spirals into bankruptcy.
A valuable resource for a construction company management team is their surety bonding company underwriter and bonding agent with contractor industry experience. They have the luxury of data comparing performing companies against non-performing and can point out trouble ahead. According to Nevin Beyer, bond underwriter for Keystone Insurers Group, some reasons contractors fail are:
- “Buying jobs.” Bidding a low or no-profit job in order to “keep their workers busy, so they don’t have to lay off anyone.” This happens quite often. It is better to lay off workers during hard times and hire them back when work picks up than to go out of business. Another reason contractors “buy jobs” is they are new and want to establish a reputation of doing good work inexpensively.
- Geography. For example, a New England contractor familiar with digging and blasting granite and rock would not understand that the “sugar sand” of Arizona collapses and fills back in at night when it dries out. Conversely, an Arizona road contractor would not be familiar with the amount of dynamite and work it takes to move New England granite or the amount of weather delay days that have to be figured into the estimate.
- Change in type of work. A roofer, desperate for work in hard times, bids a city beautification (landscaping) project. The roofer has neither the tools nor the expertise in landscape design to do this type of work, but falsely thinks it is simple because he does a good job on his home landscaping.
- Personal problems. Divorce (one spouse wants to punish the other spouse by not paying bills and destroys the credit rating of both), cancer or other devastating health problems, drug or alcohol addiction, depression/mental illness, gambling and children of owners running or taking advantage of the business.
- Misleading or Vague Contract Conditions from the GC or Obligee. In the surety industry it’s called “grinding” a subcontractor with onerous contract wording. Making a subcontractor commit to pricing, work, penalties or time that the subcontractor can’t possibly perform or afford.
- Size of Work Program. A small contractor wants to bid a $2 million job when the largest job it has performed was $500,000 or lower. The contractor does not have the experience, labor, equipment or paper management skills to execute a job this large.
According to the Surety Information Office (SIO), warning signs that a contractor is in trouble include bank lines of credit always borrowed to their limit, an ineffective financial management system, poor estimating of job cost reporting, poor project reporting and no comprehensive business plan. SIO found that in most cases contractors don’t fail because of poor construction. Most contractors build a good building. They have to undergo inspections to follow rigid design specifications.
So if they don’t fail because of poor building practices, then why do contractors fail? Simply, it is because of poor business practices. Many construction companies are started by people without specific schooling in running a business. They know how to build but haven’t been taught to run a construction company. To compound matters, there isn’t much formal education offered in running a construction company.
Every company has business practices, and if those business practices are in place and used, the company will improve its ability to make a profit. All those business practices become part of a company’s risk profile. That risk profile is at the heart of a robust risk management process 365 days a year. It’s a five-step system to identify, analyze, control, finance and measure risk proactively rather than wait until something happens and try to fix it.
One way to identify risk is by holding confidential employee interviews. It is amazing what risks a company can learn about just by asking employees’ opinions. The responses can be reported to management, who can take measures to avoid or minimize the risk.
One of the inherent flaws in the insurance industry is short circuiting the risk management process by hyper-focusing on the insurance bid, which falls into the fourth step (finance) and ignoring the first three steps (identify, analyze and control). Focusing on finance first is like starting to build the fourth floor of a building without finishing the first three. Risk dealt with by building on the first three steps of risk management doesn’t need to be financed, and results will always be best in class.