The recent collapse of EBERT Construction has brought into the open a well known problem within the construction industry: margins are often too narrow to provide contractors with a financial buffer to absorb costs if something unexpected happens.
When any business takes on a project there are risks associated with doing so, that’s why limited liability companies were created, to protect shareholders from these risks. It’s also why businesses are entitled to make a margin, it’s their reward for assuming these risks when taking on a contract. From the principal’s perspective, this margin is the cost of transferring their risk to the contractor, within the terms of an agreed contract.
Problems arise when markets become unbalanced (or companies are poorly managed) and too much risk is assumed by contractors without adequate contingency or margin buffer should the project perform poorly.
This is the crux of the argument we’re hearing currently: contract terms are weighted too heavily in favour of the principal when it comes to risk, and contractors are not securing the appropriate margin to reflect the risk they’re taking on.
Businesses in all industries face the risk of not getting paid for what they do, so what are the tools and processes you can put in place to limit this risk?
Before you start – good preparation
Do you know the annual cost to your business of bad debt? Your first step should be to work this out. Next ask yourself how much can you afford to lose if a contract goes bad? These are key figures that will help you decide how important the following measures are to your business.
1. Check references & reputation
In this industry you’re generally only going to be paid after you’ve supplied your labour and materials (although in some cases this is changing as suppliers demand deposits before supplying major components). This means it’s important to find out if your customer is a good payer before you agree to work for them. You should consider:
· Asking to see their latest financial statements (good luck getting these though!) so you can assess their financial solvency and ability to pay
· Asking for references so you can speak to previous or current suppliers
· Checking their credit rating using a system like www.creditworks.co.nz for construction companies or www.veda.co.nz for individuals or other businesses
· Asking other tradespeople about their experiences with the contractor
· Checking out review sites like www.builderscrack.co.nz and www.nocowboys.co.nz
If you get a bad vibe, rather than taking the risk, your time may be better spent doing a bit of “sales and marketing” to find better quality work. After all, do you need the work that badly that you’re prepared to work for free if it all goes pear shaped?
2. Have something in writing every time
A contract outlining the work to be done and payment terms is a powerful tool if a dispute over payment arises. Just having one in place will help ensure payments are made as agreed, but if legal action needs to be taken the old adage holds true that: “if it’s not in writing, it didn’t happen”. It may feel unnecessary in some situations but it’s better to be safe than sorry. Standard sub-contract agreements are available from most trade associations, including the Specialist Trade Contractors Federation (www.nzstcf.org.nz).
3. Register with the PPSR
To avoid losing materials and equipment you’ve supplied if a main contractor goes bust you should register a security interest in them on the Personal Property & Securities Register (PPSR). This means you’ll be at the front of the queue to get your property back. Otherwise it could be sold by the liquidator or receiver to pay secured creditors. Go to www.ppsr.govt.nz for more information and to register.
Payment security options
4. Use a service like Build Safe
For a fee Build Safe (www.buildsafe.co.nz) will hold the money needed to pay a sub-contractor in their independent trust account. You will need to make this a condition of your quote and/or contract and get your customer to agree. This approach requires the owner/main contractor to transfer funds into Build Safe’s trust account in advance of work starting.
5. Take out trade credit insurance
This effectively insures the company’s accounts receivable asset (ie. the money owed to it by customers) against non-payment. So, if the customer becomes insolvent or doesn’t pay for a protracted period the contractor can claim the cost of that bad debt from their trade credit insurer. It is more suited to large projects. Contact Builtin to enquire about trade credit insurance.
6. Provide a bond instead of retentions
Recent changes to the Construction Contracts Act (CCA) require main contractors to hold your retentions “on trust”. This doesn’t mean they have to put it into a separate, protected trust account, merely that they must account for it separately rather than using it for working capital. It means if they go bust you’ll have a better chance of getting your retentions back. But it still assumes there’s any money left to distribute.
Instead of having cash retentions deducted from your payment claims you can have an insurance company provide a bond on your behalf. Although you pay a non-refundable premium, this will improve your cash flow and eliminate the risk of losing your money if the main contractor goes bust. Your principal/main contractor will need to agree to accept a bond in lieu of retentions, but there is no good reason for them not to and objecting to this can be a red flag that they’re using your money to fund their own cashflow. A bond in lieu of retentions can easily be added as a special condition to any contract.
Find out more about insurance-backed bonds
During the contract – good administration
7. Submit invoices that comply with the Construction Contracts Act
Under the CCA valid written payment claims must be paid within 20 days of receipt, unless a written alternative payment schedule is proposed (which could be earlier). If this does not happen you can immediately start a fast-track adjudication process. The adjudicator can make a decision within a very tight timeframe and the decision is binding on both you and the contractor/owner. It is also enforceable as a court judgment. A number of trade support organisations, including the Building Hub (www.buildinghub.co.nz), have developed payment claim templates to help you.
8. Good accounts receivable processes
Whatever your payment terms are it’s important you’re quickly aware when a deadline for payment is missed. Reminder notices should be sent out swiftly and followed up to understand the reasons for non-payment. Missed or late payments are often your first indication that all is not well, and the sooner you investigate this the sooner you can decide whether to cease work until issues are resolved.
There are many good accounting, business and project management applications that help small and medium-sized trade businesses maintain good credit control. Check out www.nextminute.com for one example.
In a nutshell
Despite the best due diligence, the best contract and the best accounts administration issues will always arise. Our industry is highly fragmented, highly competitive and margins are tight, which means bad debt is a cost of doing business and the risk of not getting paid is ever present. Whether it’s related to a dispute or an insolvency, following the above guidance will help you reduce this cost to your business and increase your profit.