There are considerable opportunities for factors in the construction space, particularly working with small- to medium-sized contractors ($2 million to $20 million per year in revenue) due to the barriers to financial success inherent in today’s construction industry.
Nearly four years ago, there was abundant hope and raised expectations in many segments of the country: We were told that the historic, unprecedented levels of taxpayer funding, which would be devoted to the building and rebuilding of America’s infrastructure, would trigger a turnaround in the economy through new entrepreneurship and employment opportunities in construction.
We have seen a fairly dramatic increase in prospective deals, transactions and proposals to factor contractors and subcontractors. Unfortunately, due to their financial results of the past few years or their inability to work within a fairly structured financial management system, the majority of these small business owners have not been able to gain access to this much needed capital, missing out on many business opportunities to larger, better capitalized competitors.
Recent industry research has indicated that the mega construction contractors ($500 million and larger) have in fact, been enjoying a feast on opportunities. Of course, these large contractors come with a reservoir of financial strength, well-established credit relationships and bond credit in place.
For the small business contractors and subcontractors, generally those handling less than $500 million, and many more that are handling $25 million to $50 million in revenues per year, this bonanza has largely passed them by. While the originally stated intent of the administration’s initiatives was to see these smaller business owners, family enterprises and sole proprietors benefit — for the most part their financial condition does not permit a bank or a surety to provide them with the working capital financing they need or adequate surety bond credit.
Two other developments have emerged since the beginning of this initiative that have negatively affected the small- to mid-sized construction contractor. As we are all painfully aware, the Federal government along with many states and municipalities are now severely strapped for cash. In an effort to control their cash flow many have begun imposing new hardships on contractors, stretching out the length of time it takes for contractors to get paid for work performed and accepted. In a number of cases, these entities have altered their original rules and no longer allow for progress billing on certain types of specialty construction projects. (For example, instead of a small business contractor I am working with being able to progress bill and get paid by a Federal agency every month, this firm must now wait five months until completion of the project and then submit a single invoice, waiting an additional 30 to 45 days minimum beyond project completion to get paid.) This helps government entities with their cash flow, but it shifts considerable burden onto the contractor, further diminishing opportunities for small contractors to participate.
Changes to procurement procedures such as this dramatically reduce the number of small- to medium-sized contractors able to compete for publicly funded projects because they simply cannot carry the material and labor costs under this scenario for such a long period of time. Hurt the most are the small, minority and Service Disabled Veteran-Owned companies that many of the set-aside programs were designed to assist.
Recent examples: We have a small Midwest-based HVAC union-shop contractor that has been in business 30 years. The contractor has applied for factoring because he has depleted his cash and government agencies have been stretching out their payments. We have a West Coast-based military contractor doing projects on bases averaging $400,000 in billing, facing continuous delays on payments. We have a Northeast painting contractor doing maintenance for public transportation agencies with no cash flow, while its union-required payments are coming due.
Quite recently, a third financial landmine for contractors and subcontractors has surfaced: the galloping increases in fuel costs, which often represent 10% or much more of a construction budget, depending on the type of construction. There has been such a radical rise with indications of prices continuing to go up that it is difficult for a contractor to accurately calculate costs to project when bidding on a contract. Compounding the problem is the fact that suppliers will charge higher prices than originally quoted on materials due to this rise as well. Contractors are usually required to absorb these additional costs but current margins are too thin to absorb very much.
Due to the increase in the amount of time it is taking contractors to get paid, public works construction has a major need for factors right now and there is good revenue to be generated. However, this space poses high risk if a factor decides to get into construction factoring without being properly set up for it.
Like any credible lender, a factor first determines the creditworthiness of a prospective prime or subcontractor through a comprehensive underwriting process. This includes reviewing corporate and personal credit and financial statements and tax records for at least the past two to three years as well as judgment and litigation searches.
A factor working with construction contractors also underwrites the borrowing contractor’s ability to perform the work on the projects it wants to bid on. References are checked and performance reports for previous projects are reviewed. Of particular interest is the experience of the contractor on projects of similar size and scope and the contractor’s history of profitability.
With subcontractors the factor also underwrites the account debtor, usually the Prime Contractor. During these tough times, it is essential that both the factor and borrower determine that the account debtor has the history of paying subcontractors properly and timely for work performed on similar projects.
Prior to bid and estimating, a prospective borrower will submit information on the project requiring financing for the factor’s review and approval so he is assured that he will be able to factor the receivables on the project. If the project meets the factor’s criteria and the contractor has the capacity to perform the work, then the factor encourages the contractor to bid on the project.
Once the bid and estimate are prepared, the factor’s construction project management division completes an initial review to determine the project’s viability and the estimate’s accuracy. The factor must also confirm that the borrower can complete the project based on the estimate’s projected materials, labor and time. If approved, the factor assures the borrowing contractor that the working capital will be provided as advances on approved project receivables.
Once the contract is awarded, the factor’s construction management division works closely with the borrowing contractor on the preparation of any subcontracts. Also at award time, all contract information is entered into the factor’s construction accounting system and a trust account is created within the factor’s funds control program to manage all project disbursements.
As pay applications on progress billed contracts are generated by the borrowing contractor, they are verified and approved for payment through the use of an estoppel by the account debtor (owner or prime contractor) and a signed copy is forwarded to the factor to establish availability of funds for an advance to pay project expenses. Concurrently, the borrowing contractor submits all invoices (including project payroll) to the factor to generate project accounts payable.
The funds control program is a critical piece of the program for the factor working with construction contractors. Funds control provides that high level of assurance that advances generated based on the purchase of a project receivable are only used to pay job costs, particularly during this time when profit margins on construction are so razor thin. Through that program, the factor must insure that all payroll and labor burden is up to date on all of the contractor’s projects, whether they are factored or not, so as not to jeopardize the factor’s priority position on project receivables.
Concurrently with the financial administration on the project, the factor ensures that the borrower performs all work on the project in accordance with the contract, schedule of values, estimate and production schedule. Under this process, all change orders must be approved by the account debtor before any action is taken or invoices for the work included in the change order can be purchased to generate an advance. Periodic site visits and inspections are performed, and pay application details are verified. If the borrower fails to meet the standards of the contract, then the factor’s ability to be repaid by funds generated by the financed receivable is jeopardized — a serious encouragement for the factor to manage that risk to the fullest extent possible.
For a factor that is considering the concept of entering the construction/building trades industry, be prepared for the much higher risk this poses in comparison to other industry sectors. The time and effort to put together a worthwhile deal with independent small businesses and entrepreneurs in construction is proportionately greater than other sectors. And it is very easy to expend a lot during the “due diligence” process, only to discover because of some issue the applicant is not qualified to be a factoring client.
Although there is considerable demand for factoring support in the public sector, current research indicates that short-term growth in the construction industry will be seen in the areas of home renovation and multi-family home construction, rather than in the public sector. There are emerging opportunities — but let’s tackle that area in a future article.
Earl Harper is senior vice president at RMP Capital Corporation, a ten-year-old national factor based in Islandia, NY that focuses on transportation and public works construction, handling about $70 million in annual deal flow. Harper is the president of the Austin, TX chapter of the construction financial management association. For more information about RMP Capital, visit www.rmpcapital.com.