President Obama, along with 26 enterprises, this week announced the creation of SupplierPay, a “partnership with the private sector that will strengthen America’s small businesses by increasing their working capital.”
The SupplierPay program is a step in the right direction to bridge the working capital divide between the business haves and the have-nots but does nothing to very little for the construction industry’s massive financial risk and payment problems.
Construction financial managers (CFMs) are well-served to understand the program and the working capital trends across America, as the SupplierPay and QuickPay initiatives may just foreshadow the construction industry’s financial future.
The Working Capital Disconnect & Supply Chain Finance Theories
The below TED talk was given by Ami Kassar, a small business advocate and loan broker. The TED talk is 7 minutes long and well worth watching to get big picture insight into the nation’s working capital conundrum.
Kassar’s insightful point is nicely summed up in his recent Wall Street Journal column “Let’s Put Obama’s SupplierPay on Steroids:”
Big companies can typically borrow money at 2% or 3% interest while in our loan brokerage we find that the small suppliers are often forced into expensive factoring agreements with annualized percentage rates that average 24%. And yet historically, big companies have always taken their time to pay their small-business clients. This creates a vicious cycle, where the smaller companies are placed on high-interest treadmills. And sometimes their big suppliers change the terms, often without warning.
There is a healthy debate about how to solve this working capital challenge.
Kassar’s (and apparently Obama’s) view is the Utopian solution which asks the deep-pocket buyers to see the big picture of supply chain health and pledge to pay its suppliers faster. This is the opposite of what happened in the marketplace recently, which saw bigger companies stretching small businesses by extending payment terms and pocketing the cash float. It’s hard to see how the pledging companies are going to sustain this fast-payment practice after the good PR wears down or the economy takes any negative shifts.
A close-relative of the Utopian solution is the capitalist solution, which employs a practice known as “reverse factoring” or “dynamic discounting.” A lot of exciting companies (Taulia, Ariba) are leveraging web-based technology in this area and enabling small businesses to get cheaper access to capital by capitalizing on the ancient supplier practice “early payment discounts.” The Utopian promoters dissent to the capitalist solution because they see it as just another way for larger corporations to leverage their position and to make more money (i.e. on interest) to do something they should be doing anyway (i.e. paying their suppliers!).
Sunguard Financial Systems wrote a pithy and interesting post that underscores a problem with both of these solutions: reality! Rob Jacobson reminds all the optimists that the lowest hanging fruit to speed up working capital may not be forcing faster payment terms but in improving the method of payment. In Obama’s SupplierPay Program v. U.S. B2B Payments Reality, Jacobson reports that the volume of paper check payments is unnecessarily high, and that this is putting billions of dollars of working capital in USPS trucks.
Working Capital Problems In Construction Industry Present A Complicated Paradox
Construction financial managers know that working capital management is different in the construction industry. The industry’s complexity is fertile ground to grow nuances in how services and materials get billed and paid. The consequence of this is the creation of a working capital landscape that is a bit paradoxical to standard supplier-buyer models.
Complicated Invoicing Procedures
The first construction industry complication is the invoicing procedures. A construction project may have 100-200 different parties participating, and these parties come and go on the project in a complicated orchestration of scheduling and logistics. The parties are also individual businesses of all shapes and sizes — each uses a different software platform to control their operations and they each employ a variety of invoicing procedures.
Many have attempted to standardize the invoicing process. The establishment of contract standards (i.e. AIA, ConsensusDocs, etc.), for examples, aims to establish an invoicing or “application for payment” standard for the entire project within the contract documents. The problems with this approach is that subcontractors and suppliers must juggle multiple “standards” across their portfolio of projects, and further, the contract requirements can only affect those under contract and have a difficult time traveling down the chain to the lower-tiered subs and suppliers.
Even if a huge general contractor came out to support the SupplierPay program and take the “pledge,” it would have only limited impact, because there is so much uncertainty in the construction industry about when a payment is even due.
In addition to the mere presence of multiple parties and standards, the invoicing process itself is subject to nuance. Material suppliers will issue traditional suppler-buyer invoices for materials that are furnished on an open account. Subcontractors, however, will invoice through “progress payment applications,” which frequently has the material supplier’s invoices embedded within them. All of these payment requests must travel across a high number of eyeballs and prejudices before they are approved (or disapproved) and money starts to flow (or doesn’t).
Even if a huge general contractor came out to support the SupplierPay program and take the “pledge,” it would have only limited impact, because there is so much uncertainty in the construction industry about when a payment is even due. This problem is explained nicely by The New York Times article about a related Obama program — QuickPay — which requires the federal government to pay suppliers and subcontractors within 15 days on federal projects. Yes, even construction projects.
In the article — For Contractors, How Quick is Obama’s QuickPay? — the interviewees and author review the requirement that all contractor payments be made within 15 days, but wonder “within 15 days of when?”
This is a huge problem with any payment pledges. After all, the states and federal government almost universally already have prompt payment laws that require payment within 10 or 15 days…yet, the industry is still riddled with payment problems. Then again, in any critique of such payment pledges, one must consider the NYT article’s conclusion: “Let’s not make the perfect the enemy of the good.”
Big Companies and Small Companies Are All Mixed Up on Construction Projects
The construction industry may just be a riddle wrapped in a mystery inside an enigma. Traditionally, the supply chain sees a large well-funded buyer making purchases from a small business supplier. Apple, to take one of the 26 companies who signed onto SupplierPay, is well funded and has easy access to capital, and they purchase components, parts, and supplies from a variety of companies who are smaller than them.
This interplay between big and small companies gets all mixed up on a construction project.
A huge company like Ferguson or W.W. Grainger oftentimes supplies materials to a small business contractor. In such a case, the access to capital is cheaper for the supplier-seller than the buyer-subcontractor. To complicate things further, the ultimate buyer – the general contractor and/or developer – is hiring and buying those materials from the small business contractor, and this ultimate buyer/contractor is also typically larger than the subcontractor, with more access to capital.
The middle guy in this typical scenario – the subcontractor – is squeezed for capital on both ends. The expectation is that the subcontractor must “float the job,” and this expectation is so perverse in the industry that prequalification practices commonly require subcontractors to have a balance sheet proving that they can “float” everyone else’s capital. This despite the fact that they have the least and most expensive access to capital.
Construction Payments Are Corrupted By Payment Terms and Conditions That Are Easy To Manipulate
In the traditional buyer/seller arrangement, there are simple payment terms. One party buys something from the other and the terms of payment are 15 days from invoicing. As above introduced, even in this simple example, there are some issues as to when exactly the 15 days start to count, as most companies employ some procedure to accept an invoice. Nevertheless, the process here is explainable.
The construction industry, however, is corrupted by complex payment terms.
Notwithstanding the fact that the provisions are oftentimes void and against public policy, “pay when paid” and “pay if paid” provisions are embedded in nearly every construction contract across America. These provisions add a whole new dimension to the complication of figuring out when a payment is due for the purposes of distinguishing between a slow pay and a quick pay. Having someone in the construction industry agree to a SupplierPay-type pledge is likely to do very little. Prompt payment laws already require payment within 10 or 15 days…the problem is that no one knows from when to count.
Is SupplierPay Meaningless to the Construction Industry?
Does Obama’s SupplierPay means anything to the construction industry? The answer, unfortunately, appears to be no.
Absent from the 26 companies initiatively joining the pledge, are any meaningful construction industry players making any pledge that is meaningful to the payment flow on construction projects. Textura and Westinghouse Electric Company are both in the construction industry stratosphere, but their participation in SupplierPay simply means they are pledging to pay their suppliers faster, which will virtually never touch the payment flow on a construction project.
Further, the pledge to pay suppliers within 15 days cannot possibly be any stronger than the layers and layers of laws that require construction industry participants to make prompt payment to their subcontractors and suppliers. The unfortunate conclusion is that something more is required.
Financial Risk and Payment in the Construction Industry is a Huge Problem
It is a difficult job to find a general contractor who doesn’t go around the industry touting its “relationships” with their subcontractors, and who isn’t publicly cheering for the “success” of their subcontractors. The often-touted relationship, however, resembles those where the police often get called for domestic disturbances. The subcontractors must open their finances for the GC to see that they are solvent enough to float the project, and must compromise around every corner to maintain the “relationship” and continue getting work.
The topic of financial risk shifting is a recurring one here on the Construction Financial Journal, and even more importantly, within the industry itself.
Financial risk is an inherent characteristic of every construction project, and the various participants are constantly shoveling the risk off themselves and onto others. When top and bottom of the chain parties get together to discuss risk, they simply point their fingers at one another with blame, and attach themselves to the idea that they shouldn’t be the one to shoulder the risk. We saw this recently in the ENR Risk Summit, as general contractors complained about subcontractor default and subcontractors complained about payment abuse, leading ENR to publish a summary article proclaiming that “Perception of Risk Depends on Where You Are in the Payment Chain.”
Can Supply Chain Financing Work For The Construction Industry?
It’s clear that the cash flow situation in the construction industry presents unique challenges. The SupplierPay program and supply chain financing principles assume that the only working capital divide that needs a bridge is the timing of payment. The construction industry, however, is challenged by an undercurrent of financial risk management.
In other words, the problem is greater than the simple timing of payment. The problem is whether the payment is coming at all.
The problem with SupplierPay and supply chain financing initiatives for the construction industry is demonstrated nicely by Prompt Payment Laws. Every state has a prompt payment law, and the federal government has both a prompt pay law and a QuickPay program requiring fast payment to federal contractors. But these rules do next to nothing for the industry’s working capital problem. These initiatives are riddled with disputes about when the payment clock starts to tick, the cost to litigate these questions, and the ignorance about payment rights which makes actual usage of the laws prohibitive.
Maybe A Pledge Could Work…But Can The Industry Trust General Contractors and Developers?
It’s hard to imagine that general contractors, developers, sureties, or anyone at the top of the construction project payment chain would pledge to pay companies faster at the expense of their own financial risk exposure. No one is going to agree to make payments before a pay-when-paid or pay-if-paid provision requires payment or without all the logistics required to ensure everyone in the payment chain is being satisfied. The payment application approval and payment process is too complex.
But maybe…just maybe…a real, sincere pledge from the general contractor could help?
While optimists may get excited, a glance across the pond to the UK Construction Market may be revealing. There, Balfour Beatty has started an “early payment discounting” push, enabling suppliers and subcontractors to get early access to capital through reverse-factoring theories. The article Balfour Beatty in ‘pay for early payment’ pilot contains a comment that offers a very interesting perspective:
“So we nearly got rid of pay when paid and have replaced it with pay to get paid. What will the finance whizz kids think up next?”
This is certainly a compelling perspective, and likely the perspective that subcontractors and suppliers would take if the early payment concepts migrate to the United States (i.e. they are inevitable, by the way). Some subcontractors would argue that general contractors are already requiring them to “pay to get paid” by mandating the use of Textura to manage the payment process. See: Gripes and Complains by American Subcontractor Association Members about Textura’s Costs and Mandate of Usage.
The construction industry is one of the nation’s largest industries, and in the construction industry, financial risk is a zero sum game. Someone is going to have it. Right now, it’s on the shoulders of America’s small businesses, and Obama’s SupplierPay doesn’t give this fact any hope.