The construction industry is overly burdened by contractor failures. In fact, construction routinely leads all other industries in failure rates. The construction industry seems to present a perfect storm for driving up failure rates: razor-thin margins, significant cash demands, payment timing issues necessitating large “floats” of costs, and more all add up to a large number of failures. And, since the construction payment chain is so the interconnected, a failure by any project participant can be felt up and down the payment chain – and even on other projects.

It doesn’t have to be this way. Construction companies all benefit from strong statutory protections built into the laws of every state. These protections, when used appropriately, can shield a company from the failure of other contractors and – as an added bonus – make sure payment is made more quickly.

The best way to protect against the financial risks associated with contractor failure is two-pronged:

1. understanding and avoiding internal factors or practices that put the business at risk; and
2. preparing for and protecting against the mistakes and failures of other parties.

Internal Protections: Know and Prevent the Leading Factors that Cause Contractor Failure

There is a lot of data on the propensity of contractors to close up shop, and much of it details relatively common practices that just take a disciplined approach to avoid. Contractors of all tiers must understand these common risk factors and risky behaviors in order to avoid becoming an unfortunate statistic. Cash flow is one of the most common triggers for contractor failures. This is due in no small part to the nature of construction payment itself. Paying suppliers’ invoices with short payment terms and making sure payroll is met can cause severe strain on a company that is waiting for payment for work already performed on multiple jobs. And, taking on more work to increase revenue can exacerbate these problems in the short run. The construction industry is always cash hungry, but it helps to take a moment to consider that more business requires more cash – so the dangers of too much potential business can be just as devastating as the problems of too little.

In order to best protect the company from these cash risks, the following steps should be taken:

• get financial documents in order and make cash projections each month; use these projections to guide the company as to which projects to accept, and which to discard;
• always plan ahead to secure cash financing and availability before the company gets desperate;
• don’t get greedy and take on too much work (compared to cash reserves and ability to navigate floating significant associated costs related to potential slow payment);
• be careful with bids and estimates, and don’t promise to do projects for too low a fee, relying on good luck or change orders to make up for unexpected costs; and
• take steps to improve the timing of payments by providing notices and remaining in a secure position.

External Protections: Prepare for and Protect Against the Mistakes and Failures of Other Parties

Understanding the default risks and taking proactive steps to keep a company healthy is only one part of the equation. By itself, though, it is not enough. Exercising extraordinary discipline and good cash management practices is a crucial part of avoiding failure, but even a carefully constructed protection wall can come crashing down like a house of cards due to the poor practices of other companies on a project. Diligent cash management is only part of the necessary story.

The web of construction payment means that one company’s default, delay or poor workmanship on a project – no matter where that company is on the contracting chain – can cause problems for everyone, so it’s equally critical to prepare for everyone else’s cash management to be a mess.

While there are numerous methods (of differing effectiveness) to protect against other parties’ failures, by far the most effective is to always protect mechanics lien and bond claim rights. Mechanics liens give a contractor an interest in the improved property itself and enable the contractor to skip right past the defaulting contractor to seek payment directly from another interested party, including the prime contractor or property owner. It even allows the contractor to actually foreclose on the property itself in order to get paid. If a customer is having cash problems or is slow to pay, these security instruments can be incredible tools, and the difference between a write off and cash in hand.

Further, the process of informing all parties up the chain that the company is on the project, when otherwise they may not know, and that the company’s rights are protected, puts the company at the front of the line for payment and prioritizes payment over others if money gets tight. Providing notice, which is generally required to maintain these security rights, makes a company visible and opens up an avenue for communication and dialogue between parties. The mere act of having a forum for discussion available can help a contractor avoid many payment disputes or other sticky payment issues.

Construction is a tough business, but following the steps outlined above can make the difference between success or adding to the pile of contractor failures.