The construction industry is difficult. Low margins, combined with long time-to-payment and the necessity of floating costs across multiple projects can lead to dire consequences. These consequences can go beyond project-specific difficulties and result in business failure.

In fact, construction has one of the highest failure/default rates of any industry. (One recent study put the failure rate of construction businesses at number two, second only to restaurants.) This comes as no surprise to any construction participant in a theoretical sense, but it always seems to take companies by surprise when they (or one of their subs) is staring down the barrel of needing to close up shop. 

But, given the all-too-common nature of construction business failure, it’s important to understand the triggers and underlying causes so that they can be avoided; or, at the very least, to grow a better understanding of how to manage the risk. 

There are many ways that companies can seek to avoid or lessen the risks associated with subcontractor failure, but understanding the “why” behind subcontractor failure instead of focusing on the symptoms can help fix the problem at the source.

Main Causes of Subcontractor Failure

Cash Flow

The simplest explanation for business failure is that the business simply runs out of cash. While there can be many reasons for a poor and unmanageable cash flow, the key issue is that subcontractors often are expected to float the project costs. 

Since the average time-to-payment for subcontractors is about 75 days from invoice/pay-app (not including retained amounts), subs incur multiple expenses prior to receiving payment. Material costs and weekly or bi-weekly payroll/laborer obligations all add up – and must be paid while the sub waits and waits for payment. Now, extrapolate that to multiple jobs all of which are racking up costs prior to payment, and it becomes clear that these are unrealistic expectations for any company that is not flush with capital.

Lack of Access to Capital

Since a company needs to be flush with capital to navigate the necessity of floating project costs – where does that required capital come from? Unfortunately for subcontractors, it’s really difficult to get capital access from traditional banking sources. In a regrettable catch-22, it’s the high failure rates and low margins of the construction industry that make lenders reluctant lend money out to subs. And, when funding is obtained, subcontractors generally must pay higher rates, putting them into a vicious cycle of interest payments and cash needs.

Difficult/Lengthy Approval Process
Subcontracting is not like a retail business. It’s pretty simple to sell something and receive cash on the spot. However, in construction, work is layered upon the work of many other parties; the work itself must meet a subjective-type approval; and there are many things that can go wrong on the jobsite that puts the subcontractor in practical or legal crosshairs. This all feeds into the aforementioned problems, as this is yet another cause for heightened cash needs.

How to Manage and Mitigate the Risk of Subcontractor Failure

The failure of any party on a job has a ripple effect that can cause far-reaching problems. But, given the difficulties discussed above, is there anything that other construction participants can do about it, or do to guard against it? While none of the following methods are a panacea (the only cure-all for this problem is a shift in the paradigm of construction payment itself) they provide some ways to mitigate the risk.

Prequalification

Top-of-the-chain parties often use prequalification to assess the likelihood of failure by a lower-tiered party (e.g., a subcontractor). Lower-tiered parties also can use prequalification to assess the problems that might arise by higher-tiered parties. Everyone is affected by default and should do preliminary analysis to avoid it. Examining the ability of a subcontractor to deal with expected cash flow challenges is a necessary evil although one that can be mitigated through the lien rights process. 

Lien Rights

While the lien rights of the GC don’t really apply to subcontractor default, a sub’s own lien rights certainly do. In an industry in which payment to a sub can be not a sure thing, the ability to secure the amount due is crucial. Rather than attempt to thwart a subcontractor from protecting themselves through the right to file a lien if needed, a prudent and savvy party will work to facilitate the subcontractor’s lien rights. Further, since remaining secure prevents companies from being placed into the back of a payment line, a subcontractor that has retained its lien rights is insulated from others defaulting on the project.

Surety Bonds

Subcontractors can obtain performance bonds and payment bonds, and it’s common for general contractors, owners and lenders to require some subcontractors to acquire these bonds. When a subcontractor has these bonds, a default is less burdensome because the surety bond will compensate the affected parties for the losses.