The construction industry runs on credit. Almost every construction industry participant furnishes their work and/or materials without requiring payment prior to delivery. On many projects, the value of the labor and/or materials furnished is substantial. This credit-based payment scheme extends all the way through the payment chain. Most companies both extend credit, and need a line of credit of their own. It is not uncommon that the payment of a company’s own bills is delayed until payment is received from parties higher in the contracting chain. Construction’s credit-heavy system presents challenges for Construction Finance Managers (CFMs) and other credit professionals who work in the construction industry. Several of these challenges will be discussed below.
The challenges of credit in construction
Everybody on a construction project is waiting for money from the top of the contracting chain, and the further down-the-chain a project participant is, the more opportunities there are to experience hiccups or abuses in the payment process.
Money can slip through the cracks on construction projects in a variety of places, and, there are also many reasons why payments get delayed. Because everybody on the project is waiting for the parties above them to get paid before they are, any little inconvenience, delay, or dispute about any component of the work can impact payment for everyone on the project, whether or not that party was directly involved.
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Further, this payment structure can make it impossible for some companies to pay all of their invoices on time. If a party is forced to wait for payment from parties higher on the payment chain, that company may not have enough ready cash to float the invoices received from parties below – and that puts further pressure on the payment chain as a whole.
A (misplaced) fear of sending or receiving notices
Remaining in a secured position when credit is extended should be a primary goal of CFMs. Extensions of credit that are secured by collateral “(generally the improved property itself) are much more likely to get paid.
Security, in the form of the ability to file a valid mechanics lien, is the number one weapon to combat non-payment in the construction industry. A crucial component of remaining in a secured position is sending a preliminary notice on all projects for which a notice is required.
Further, even on projects for which a notice is not required, a preliminary notice can be effective to prioritize a company’s invoices. Quality CFMs therefore, understand the value of preliminary notices, and security.
Despite this, however, many businesses are reluctant to send preliminary notices because they believe that it will alienate customers, by impugning the client’s integrity, appearing that the company doesn’t expect payment, or being combative or confrontational.
These fears, while real, are not the prevailing view of the marketplace, however. All large contractors, and property owners are getting many, many notices on every project. In fact, most like to receive preliminary notices because it makes parties on the project more visible.
Also, in some states, the failure to send certain notices destroys future lien rights.
Growth squeezes cash
Construction companies fail at a much higher rate than businesses in other industries. This business failure happens at an even higher rate during periods of economic recovery/growth. This seems odd, but when viewed in light of the unique payment structure outlined above, it begins to make sense.
The construction industry is cash-hungry, and subcontractors are generally expected or required to float substantial project costs. This can be a significant problem for companies that are not already swimming in cash, and can become deadly if many projects are ongoing.
Not only is this challenging to manage for that particular company, it is also a problem for the companies that are attempting to manage extensions of credit to that company. If the stresses of the expanding economy are causing financial distress, it results in riskier extensions of credit, and the possibility of more write-offs. A prudent CFM will take this into consideration, and require credit checks and mandate the use of security to offset these risks.
Securing credit extensions
Security is an important part of the credit management of construction projects. Extensions of credit that are secured get paid more often, and CFMs should work to make sure every extension of credit is secured to the greatest extent possible. This is difficult in some cases, and can be especially difficult with the rapid rise in popularity of the Public Private Partnership or “P3” project. On P3 projects, the available security may be unclear, or may not exist at all.
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On a P3 project, the contractual obligations, and rules and requirements regarding potential protection may be very different than what a CFM is used to in the ordinary course of business. This seems counter-intuitive since P3 projects are not a “new” project type created out of the blue, and function as “actually” either private or public in nature. However, there are considerations and complexities that do not occur on “regular” projects.
To make the management of extending credit on such projects even more complex, the determination of the underlying nature of the P3 project does not provide all the necessary answers – in fact, it just starts the process.
If a mechanics lien is determined to be the appropriate remedy to secure an extension on credit, it then must be determined if there is a sufficient private property interest to which a mechanics lien may attach?
It’s unfortunate, but in some instances, this project type can leave project participants with no ability to secure their extensions of credit.
Credit management is a difficult job. Managing credit in the construction industry is especially challenging. Challenges and issues unique to the construction industry conspire to create a complex credit management environment.
Some of the challenges described above can be avoided, but a failure to be aware of the potential dangers can be disastrous. Responsible and prudent CFMs know of these risks and take appropriate steps to minimize them as much as possible.