To grow a construction business, contractors often pursue larger projects. However, larger projects come with greater risks and additional challenges. Some contractors watch as their gross profit margins decrease when they take on larger jobs. Large, multi-year projects are also more likely to face risks from potential economic changes, supply chain issues, and other unforeseen pressures that can threaten them.
Whenever you need to get construction bonds to perform work on a proposed project, your priority is to show the surety company how you plan to manage the particular risks and minimize the downside.
For these reasons, surety companies carefully consider multiple risk factors when bonding construction projects before they will agree to underwrite a construction bond. Knowing the risk factors that bonding companies consider might help you better evaluate whether a large project you are looking at is a good opportunity. Here are some factors you should consider to increase your chances of success with a potential project and your ability to secure a construction bond.
1. Scope of work compared with past projects
When you are considering taking on a larger project, it’s important to consider the scope of work as compared to your past projects. One of the factors surety companies will consider is your experience handling projects of similar complexity.
Even though a project might be larger than projects you have performed on in the past, that doesn’t necessarily mean that it will also be more complicated or carry a greater degree of risk.
For example, if a contractor has completed projects running several hundred linear feet of pipe in a rural field, a 2,000-foot installation job might be larger but not any more complex.
By contrast, a 1,000-foot linear pipeline project in a busy area of a city might be more complicated than a 3,000-foot pipeline project in a rural area, because of unmarked utilities, permitting issues, reduced work hours, traffic considerations, and more.
A bonding company will want to understand the scope of a project and how it compares to work the contractor has completed in the past. Contractors need to be able to show the surety that they can perform the work on the project, including the ability to track job costs on a daily or weekly basis and having the right equipment and personnel to handle the various tasks.
Being able to communicate these elements to your surety clearly can make the difference between being approved or declined for a construction bond. In some cases, prior to speaking with the surety, it is helpful to prepare an itemized list that breaks the project’s contract value down by scope and/or subcontractor.
2. Reputation with past suppliers, project owners, & subcontractors
Surety companies consider your reputation with past suppliers, subcontractors, and project owners with whom you have performed work. If you have experience working with some of the players involved in the proposed project — the architects, engineers, project owner, and others — it can be helpful to your construction bond application because your experience with the various stakeholders might mitigate some of the unknowns.
As a part of your bond application, you will likely be asked to submit letters of reference from past suppliers, subcontractors, and others with whom you’ve worked in the past. If some of those parties are also involved in the project you are pursuing and provide you with strong references, the surety might deem you to pose less risk than if you are inexperienced, have few references, or have had problems while you were performing work on past jobs.
The surety is also likely to explore a contractor’s payment history on past projects — an inability to make on-time payments to subcontractors and suppliers can increase the risk of mechanics liens or bond claims.
Trust takes time to build, and demonstrating that you have built trust and performed as promised in the past shows that you will likely follow through on your obligations with the proposed project, too.
3. Sufficient working capital
The construction industry has one of the highest rates of business failure. When a contractor goes under, it is often because they don’t have sufficient working capital.
Before you take on a project, you will need to ensure that you have enough working capital to handle the job. You can calculate your working capital by adding your cash on hand with your accounts receivable that are under 90 days. You will then add your under-billings to this total. Next, subtract the sum of your accounts payable, short-term debts owed, and over-billings.
Sureties calculate working capital more conservatively than other credit providers or banks.
Contractors should generally have enough working capital to cover 10% of the new project combined with their backlog. This guideline can vary based on the scope of a proposed project, the type of construction work in your backlog, the ratio of labor costs to material and equipment costs, and your history of completing projects at originally estimated margins.
It is also helpful to provide the surety with a cash flow projection for the project. In the event of issues, access to additional sources of liquidity, like a bank line or personal funds, is also important.
A professional surety advisor or broker can help you understand your working capital requirements before you can get bonded on a project.
Your available cash flow can also be affected by the payment terms and retention amount. Similarly, jobs that have larger components of suppliers and subcontractors might have a lower impact than a project that will involve heavy labor requirements.
You should also have a line of credit with your bank between 5% and 10% of your expected annual volume. The percentage might vary based on how much cash you choose to carry and the type of contractor you are.
4. Ability to absorb losses
Contractors go into jobs to make profits, but sometimes, unforeseen problems can lead to losses. As a general rule, you should be prepared to lose up to 10% on a project and have the ability to absorb that type of loss. Considering the worst-case scenario is important for evaluating a potential project.
If you can’t afford to lose 10% on a project while still having enough working capital to finish your backlog, you will be viewed as having a significantly higher degree of risk. This is especially true if you are involved in several large projects simultaneously.
One way to reduce the risk is to require subcontractors to purchase a bond to reduce your liability for non-performance. GCs can also purchase subcontractor default insurance to reduce this risk.
Surety companies generally want contractors to take on jobs that are no more than twice the size of the largest projects they have completed with similar scopes in the past. However, if the surety evaluates the previously listed factors and finds that your overall degree of risk is relatively low, it might approve you for a project that is three to four times the size of your largest past project.
Credibility is the key
Surety support is a reflection of good business performance. Present your good performance to the underwriter and be transparent. Experienced surety underwriters can often handle bad news — but they are less accommodating of surprises.