Illustration of financial risks in construction

The way that payment works in the world of construction projects is unique, and forces construction businesses to carry a lot of financial risk. The credit heavy nature, the high number of businesses involved, and the lack of visibility into who is doing what work, make payment issues all-the-more likely for parties both at the top (lenders, property owners, general contractors) and bottom (subcontractors, material suppliers, equipment lessors) of the chain.

Related: How the construction payment chain delays payments and increases risk

If you’ve experienced late payment for construction on supply work (or non-payment), you’re not alone. Keep reading to learn what makes construction payment so complicated, and how to avoid these issues.

Construction’s Problem of Assigning Financial Risk

Most companies both extend credit and need to borrow money. Historically, participants in the construction industry have had a remarkably challenging time getting paid, or properly controlling payments, and it’s easy to see why.

The construction industry is a credit-heavy market. Instead of requiring payment up-front, before delivering materials or performing work, almost all materials and labor are furnished in exchange for a sort of I-O-U. Labor and materials are supplied with the understanding that payment will be made later on. This is true for the general contractor all the way down to a supplier to a sub-subcontractor.

It’s also true that the value of the labor or materials supplied on credit can be quite substantial — on the order of millions of dollars. This credit-based payment scheme extends throughout the payment chain on every project: most companies both extend credit and need to borrow money.

Quite often, businesses must wait until they receive payment before they can pay their own bills. And just as often, they are awaiting payment for work they’ve already performed. Because of this, the structure of financial risk on a construction project increases in proportion to distance from the top-of-the-chain (i.e. the source of money).

There are many places for money to slip through the cracks, and many reasons payment gets delayed. Because of the interconnectedness of the payment chain, any little inconvenience, delay, or dispute about work can impact payment for everyone on the project, whether or not that party was directly involved in the situation. (There is a domino effect.)

Further, this environment requires companies to make choices regarding which invoices to pay on time. Companies that are forced to wait for payment from parties higher on the payment chain may not have enough ready cash to float the invoices received from parties below.

Shifting Financial Risk in Construction

Parties higher up on the contracting chain are generally able to exert more leverage over the payment process. This is because the money passes through fewer hands to get to those parties, and is less likely to become stuck. The top-of-chain parties are not without their own financial risks and difficulties, however.

Read more: The step-by-step guide to reducing financial risk

Chief among these difficulties is the problem of visibility on the project, and the associated risk of mechanics liens from unknown parties far removed from the GC. After all, a GC cannot control the money and make sure a supplier is paid if the GC has no idea that the supplier was even working on the project.

In response to these concerns, top-of-chain parties have developed contractual provisions designed to shift financial risk away from them and onto others. Chief among these risk-shifting clauses are the pay-if-paid / pay-when-paid clauses that seem nearly ubiquitous in payment contracts.

Pay-if-paid construction contract laws

Pay-if-paid / pay-when-paid clauses are so well-known and accepted in the industry that it can be difficult to understand how odd the practice is. Courts have made their own decision about these clauses, looking upon them with disfavor.

General public policy of the United States has long been, and continues to be, that the majority of the financial risk on construction projects should be held by the parties closest to the money. The chief tool for enforcing this policy is the mechanics lien.

Mechanics liens are statutory security interests in the actual property being improved by the project. Nearly every person or business that works on a construction or renovation project is given the right to file a mechanics lien. However, in order to prevent taking advantage of the property owner (and other top-of-chain parties), you must meet certain requirements, and take specific actions, in order to retain the right to file a lien.

These requirements include sending specific notices and meeting deadlines (to send notice and file the mechanics lien). When these requirements are met, however, the allocation of risk is shifted to the parties above you.

Since nobody wants to bear the burden of financial risk, top-of-chain parties have begun to use other means to manage and chip away at the risk of a lien on their projects. Chiefly, it is routine for parties to request a lien waiver in exchange for payment, no matter which level of the chart you fall into.

Lien waivers are intended to remove the risk of lien as payments are handed out throughout a project (though mis-use of lien waivers is not uncommon). A waiver is a sort of receipt that says, in exchange for payment of $5000 (for example), you give up your right to file a lien for that $5000.

Property owners often include in contracts with general contractors a “no-lien” provision, which charges the GC with preventing a lien from being filed. This task becomes quite challenging on larger projects with many businesses doing work — it’s difficult for a GC to obtain a lien waiver from a sub-subcontractor two or three layers removed.

The right tools reduce financial risk

The construction payment process, while complex, convoluted, and messy, can be made fair and manageable with the right tools. These tools include legal documents and provisions (lien waivers, notices and mechanics liens), and technological tools (software applications that manage payment processes, lien compliance, and lien waivers). Proper use of these tools protects top-of-chain parties from double-payment and surprise mechanics liens, and it protects bottom-tier parties from non- or late-payment.

Fair practices and participation are required from everybody in order to achieve successful projects with timely payment.

Construction Risk Management: The 5-Step Process to Reduce & Manage Risk

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