Drop a hammer off a high-rise and the impact could be deadly. Stretch a subcontractor out too long on payments and it could have a similarly devastating effect.
According to a recent survey by TSheets, more than a third of construction contractors experience cash problems at least once a month. That’s not surprising considering a 2018 study of working capital by PriceWaterhouseCoopers found that half of construction subcontractors are waiting 84 days or more to get paid – the longest wait of any industry measured.
Peter and Paul
The longer it takes for a business to convert capital to cash, the greater the risk of that business being unable to cover expenses or accept new work. If that happens too often, it could lead to work stoppages and even business failure. The smaller the company, the more difficult it can be for them to meet their financial obligations, given the prevalence of unfavorable contract terms such as “pay when paid,” and “pay if paid.”
Such practices evolved for a very good reason — to protect general contractors, who are often also highly leveraged and are stuck between subs with their hands out and owners holding tight to their purse strings. Nevertheless, this tradition of robbing Peter to pay Paul really only kicks the can of payment risk down to those most desperately in need of immediate cash.
Financial “experts” recommend that small businesses keep three to six months of cash expenses in reserve to cover payment delays. But as they say in the real world, “results may vary.” According to a recent report from JP Morgan, the median cash reserve for a construction contractor is 20 days — which may explain why U.S. Census statistics show construction companies have the highest failure rate of any industry with only about a third surviving five years.
The Subcontractor’s Dilemma
Loans are an excellent source of cash for capital investments that allow companies to increase revenue and spread the expense over time. They are also a good way to cover cash timing needs when there is a clear and predictable income stream available for repayment.
Neither of those scenarios apply to construction subcontractors, who are often in the unenviable position of being the unstable middle, sandwiched between a large and creditworthy GC and a similarly large supplier.
Unfortunately, while banks may be reluctant to provide subcontractors with traditional business loans, they don’t seem to have any problem allowing business owners to run up large balances on high-interest credit cards — especially merchant cards, which often carry interest rates of 25 percent or more. And if a business fails, credit card debt typically becomes the personal responsibility of the cardholder.
Why GCs Should Care
When subcontractors fail, GCs have to scramble to replace them. That’s not always easy, especially in a booming market. Subcontractor turnover adds a whole new set of potential challenges, including project delays.
On the other hand, when subs aren’t desperate for cash, there are benefits for GCs as well:
- When subs aren’t worried about how they’re going to pay their suppliers or sub-subs, they can spend more time focused on the project and timeline.
- Quick pay enhances trust and creates a healthier environment, strengthening relationships between GCs and subs.
- Faster cash stabilizes supply chain by eliminating “kick the can” effect of cash shortages rolling downhill and contributing to business failure statistics.
A Better Way
In response to this set of challenges, a growing number of general contractors are applying technology and third-party funding to accelerate payments to subcontractors through a process known as “supply chain financing.”
Supply chain financing, which is already widely used in manufacturing, has only recently begun to get a foothold in construction. Turner Construction was among the first large general contractors to adopt such a program, launching its Accelerated Payment Program in 2014. Alston and KAST offer similar programs.
Unlike traditional small-business lending, which relies on the creditworthiness of the subcontractor, accelerated payment programs leverage the credit of the owner and general contractor.
Here’s how it works at TBS Capital Funding:
- A GC works out a deal with an investor to purchase payment applications (pay apps) submitted by subcontractors for completed work.
- The Investor immediately pays subcontractors, minus a nominal convenience fee.
- On pay day, when the pay app would normally come due, the GC pays investor instead of the subcontractor, who has already received an accelerated payment.
In this scenario the subcontractor gets vastly improved cash flow, the GC mitigates the risk of the subcontractor failing, and the investor is able to make a low-risk investment, based on the creditworthiness of the GC and the project owner. Even better, the subcontractor can turn accelerated payment feature on and off according to cash needs.
And, unlike a traditional bank loan, where each subcontractor would have to submit financial statements and go through a lengthy approval process when a GC offers accelerated payment, subcontractors simply need to opt-in to participate. And getting cash can be as simple as clicking a button on a mobile phone app.
Peace of Mind
Construction should be a rewarding business, with skilled trade workers coming together under the direction of a GC to help bring owners’ dreams to life. Anything that interferes with that goal is friction that should be eliminated.
Supply chain financing through third-party funders, such as TBS, is a process improvement that benefits subcontractors, GCs and owners alike by providing peace of mind and mitigating the risk of work stoppages due to subcontractor financial stress.
Although relatively new to construction, supply chain financing is a proven practice and I predict it will become a best-practice for construction businesses over the next decade. With competition for skilled trades on the rise, GCs should be doing everything they can to attract and sustain a stable base of subs. A technology-enabled supply chain financing program to help subs better manage their cash flow is a giant step in the right direction.