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On Monday, Textura Corp. (TXTR) reported that its largest shareholder, Northwater Capital, was “changing its role from providing venture support to one of activist,” because the investors believed that the company needed to pursue strategic alternatives. According to the letter from Northwater Capital, “three interrelated factors…should influence Textura’s strategy…the anticipated growth, the associated risks, and its cost of capital.”

In defining these three factors, Northwestern Capital identified two specific “hurdles” confronting the company. First, the speed by which the “field of large scale systems” or “mega-players” are moving. Second, the fact that Textura is stuck in the cyclical field of commercial construction and unable to get out and expand outside this field.

In other words, according to their biggest investor, Textura is at a dead-end.

Is Textura’s Business Model Creating Their Own Hurdles?

The Northwater Capital letter states that Textura used an “unfamiliar business model” to make “great strides in ‘automating an industry.” The fact remains, however, that Textura has not “automated an industry.” Northwater Capital clearly states in its letter that the “addressable market within the construction industry is very much larger than that currently captured”. One of Textura’s primary hurdles is that appears unable to expand throughout the construction industry, and instead has limited itself to commercial construction by virtue of its business model. Even more significantly, and what Northwestern Capital doesn’t say, is that the company is stuck in even a smaller niche: that of large commercial construction projects.

Furthermore, while Textura’s largest investor brags that the platform has “network effects,” they don’t dig into Citron Research’s warning about those “network effects;” namely the rate of “subcontractor churn,” and how Textura’s business model necessarily dis-incentivizes subcontractor buy-in. Read the Citron Research Reports on Textura here: Wolf of Wall Street and The Fraud at Textura.

While the Northwater letter outlined some true and significant hurdles, the question we have here is whether Textura’s real problem is actually it’s entire business model.

Part 1: Is It Too Hard For Subcontractors To Like Textura (Even A Little)?

For a company to have “network effects,” the company must provide a product that its users like so that there is substantial use throughout the entire network. Textura has a few hundred general contractors using its CPM application, but a few hundred thousand subcontractors users have passed through the application. This much larger segment of the industry is where the proposed “network effect” would exist, but there is some question as to whether subcontractors like Textura at all.

As any subcontractor knows, Textura’s business model is to sell the product to general contractors and then force adoption (and payment) by all of the subcontractors. Subcontractors historically aren’t great fans of this business model. See, for example, a 2012 letter from the American Subcontractor Association (ASA) president about subcontractor “gripes” about the solution. More recently, the ASA wrote an examination of the “Construction Payment Management” system’s terms and conditions, concluding that:

1. Textura’s CPM “allows general contractors to be unduly rigid in the processing of payments”
2. The Textura CPM “user experience is often than the generals blame the system and use it to delay issuing payments”
3. “Subcontractors have no leverage to negotiate the Textura terms and conditions;” and
4. Since Textura CPM provides “no protections for subcontractors, subcontractors must be vigilant and persistent in negotiating with general contractors the terms of use of that system.”

Any subcontractor distaste for the Textura CPM shouldn’t come as too great of a surprise to the company and its shareholders. In fact, one of its shareholders – Goudy Park Capital – completely marginalized the importance of subcontractors to the company in this quote:

If a subcontractor is unhappy, the GC will just go to the next subcontractor down the line.

Textura’s platform is sold to general contractors, property owners, and lenders, and then subcontractors are forced to use the tool. In selling the platform to these parties, Textura must necessarily promote that it helps those parties mitigate their financial risks and legal exposures. The trouble is that this doesn’t help the subcontractor end users. To the contrary, because of common financial risk shifting tactics, Textura use likely hurts subcontractors.

Textura’s largest shareholder mentions network effects, and is seemingly is not pleased with the speed by which Textura’s “network effects” are taking hold in the market, but does not swim upstream to inquire why that is. It seems that Textura’s business model, the attempt to position itself as the go-to platform for the industry’s largest GCs, arbitrarily (but necessarily) limited itself to a tiny segment of the addressable market in the construction industry and positioned itself as an adversary to the remaining larger portion.

Textura is aware of its image and use problem with subcontractors, and is trying to get subcontractors on board. They put out a self-serving press release every few months that their application is the “choice of subcontractors,” in California, Georgia, and Texas for example. They pay to be a platinum sponsor of the American Subcontractor Association, and more.

Does the strategic problem actually reside within Textura’s business model? Is the Textura CPM business model unfair and abrasive to subcontractors? Maybe it works when Textura sells to huge, powerful, and heavy-handed general contractors, on big commercial construction projects…but is this exactly why it doesn’t scale into other parts of the industry, and potentially to other industries, as well?

Part 2: Do Big Commercial Projects Uniquely Enable Textura’s Solution In Way That Doesn’t Apply To Other Industry Projects, Or Other Industries?

While the potential expansion of Textura’s model to other industries is a nice story for the investors, the reality is that the “addressable market within the construction industry is very much larger than that currently captured” by Textura. This may be directly related to the way in which leverage is exerted on large commercial construction projects – which is not necessarily mirrored in other construction segments or in other industries.

When Textura announces that Turner Construction will use it’s CPM solution across all of it’s projects, it’s not difficult to see how this deal was struck. Turner Construction has a lot of leverage with its pool of subcontractors because it controls a high volume of commercial projects, and it has a large number of subcontractors in line waiting to bid on that work. Indeed, as noted above by a Textura investor, “[i]f a subcontractor is unhappy”, Turner Construction can “just go to the next subcontractor down the line”.

The relationships between smaller general contractors and its subcontractors, however, are more nuanced. Smaller commercial projects, residential projects, and other construction projects are performed by these smaller players. These smaller players lack both the desire and the necessary leverage to force a payment management solution like CPM on their associated subs. Therefore, as Northwater Capital explains, the market is much, much larger than that which Textura has been able to capture. Similarly, in alternate potential verticals, there may not be the appropriate leverage held by few top-of-the-food-chain parties to allow this business model to work. Because of this, “Textura is not in a position yet to diversify its industry exposure” outside the field of commercial construction.

It’s hard to see how Textura will ever make significant gains into the large portion of the construction industry that remains inaccessible and untapped so long as the prevailing view is that Textura is adverse to subcontractors. And then, it’s hard to see how Textura can change its business model to embrace subcontractors without alienating its mega-player general contractors, lenders, and owners.

Everyone Benefits From A Fair Construction Payment Process

There is nothing inherently wrong or unfair about the construction industry’s payment processes. However, the process is riddled with problems. As explored in a great ENR piece by Richard Korman, the Perception of Payment Risks Differs Depending On One’s Place on the Payment Flow Chart. Those at the top (GCs, owners, lenders) work to “stay ahead” of the subcontractors. Those at the bottom (subcontractors) face huge working capital challenges and are victims of payment abuses.

Textura’s CPM business model appears to be weighted very heavily in favor of those at the top of the chain, and in helping those parties “stay ahead” of subcontractors. This takes an already troubling industry problem for subcontractors and makes it worse. This is best explained by the American Subcontractor Association article in their recent Contractor’s Compass titled ASA Attorneys’ Council Examines Terms and Conditions of Textura’s Construction Payment Management System:

Precisely because subcontractors can be at the wrong end of leverage in the payments process, industry participants have spent decades trying to insulate themselves from those problems. The legislatures created mechanics lien laws to ensure subcontractors are paid. General contractors combatted with contingent payment clauses and lien waiver contracts to push the risk of non-payment off their shoulders. And on and on.

What if the best way to insulate against problems and risk was just a commitment to fairness?

There is a way for lien waivers and payments to get exchanged technologically, efficiently, and most importantly, fairly, without one party exerting unfair leverage over the other. Just as the general supply chain marketplace is starting to see the benefits to fair and fast payment with initiatives like SupplierPay, the construction industry needs an ambitious and transparent commitment to fair and fast payments.

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.

Conclusion

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.