Our inaugural episode explores why construction companies fail — why they struggle with cash flow more than other industries, and strategies to tame financial issues.
Today we are talking with Brent Chambers, Executive Vice President of CapitalPlus Financial Services, a factoring firm based in Knoxville, Tennessee that specializes in helping construction companies of all kinds grow and succeed. Founded in 1998, they are a unique blend of financial and construction industry experts. Brent brings us 37 years of expertise in engineering, construction operations, and finance.
Lisa: Today, we’re talking about why construction companies struggle with cash flow more than some others. So let’s just jump right in.
Mr. Chambers having worked in the financial business for years, I’ve always heard that construction businesses have a higher fail rate than most. In fact, I understand that as few as 35% survive more than five years. So just why do construction firms tend to struggle more than most other businesses?
Brent: So first Lisa, let me say thank you for allowing me to join you here today. This is an important topic and hopefully discussion will be rewarding to our listeners and to colleagues in the construction industry.
The answer is that there are many reasons why small or startup businesses end up failing. Looking at this question at a fairly high level, one common denominator for failed businesses is that the new business owners don’t have a plan. They don’t have a plan, they don’t have a roadmap, and quite frankly, they don’t even know what they want their businesses to grow up to look like. They launch and then end up operating the business by the seat of their pants. Now often, you know, these new business owners, these new startups, they’re good entrepreneurs, and some are really talented at a trade, as is the case in the construction business. But they think this is all that is required to succeed. There’s an old adage in business, “If you fail to plan, then you can plan to fail”, and many will add a little more color to this. With regards to the plan without a comprehensive plan. Many new business owners have not thought through how they build a sales pipeline. That is, where are they going to get their opportunities, and where’s their revenue going to come from? They haven’t defined their target audiences, they haven’t defined their target clients, industries, and how they’re reachable. Now businesses can grow their business in multiple ways or build their revenue stream through sales teams, through marketing efforts through word of mouth, or all the above. But at the end of the day, even if they’ve thought through this, the question is, how do they put those in place? Do they know how to hire the sales team? Do they know what a good marketing team looks like? Heck, many of these startups don’t know how much revenue it takes to cover their costs, and even turn a profit. And Lisa, what I found is that the ones that do have a plan, they don’t work the plan. They get busy, and they never pick it up again, a business plan is candidly a living document, it’s one that you pick up routinely, you measure your results against the plan, and then you modify it as conditions change in the business. So, the plan is essential to success.
Frankly, many businesses have some luck, they don’t have a plan, they get up there running, and they only find themselves lacking the proper revenue to make things work, to make ends meet. So, what they do at that point in time, they convinced themselves that they just need to diversify their services. “All I need to do is both own and other service and I’m gonna be fine.” What happens there is they get outside of their wheelhouse, get outside of their sweet spot – the service that they know. And then ultimately and typically performance lags. In a new startup business performance issues will become a death knell.
Reasons Construction Companies Fail
Now, as I said, there are many reasons why firms fail. And the construction industry is not immune to any of these by any means. However, if I had to name one thing that adversely impacts the construction business more than most it is without a doubt, cashflow problems. These businesses just don’t have the available cash to float the company. And a lot of people haven’t thought through this. They haven’t planned it and they don’t have a line of credit or another available capital source like factoring.
What Causes Lack of Working Capital?
Lisa: So what do you think are the top drivers for poor cash flow?
Brent: Well, there are many aspects of a construction business that will impact the working capital. But there are two primary factors that really just drag down cash flow. One of them is, is the pay terms that they have with their customers. And the second is just out-of-pocket expenses for materials and supplies that they have to purchase up front.
1. Payment Terms
So let me tackle the paid term. First, it’s probably a little easier to discuss, and maybe we’ll make most sense to the audience. Most industries, well, all industries and all purchasers will establish a pay term with their clients and vendors. Most industries have a, let’s say, 30 to 45-day pay term. That is you deliver a product, you invoice for that product, and then you get paid 30 to 45 days from the invoice that you’ve submitted.
Now on the construction side of the world, pay terms have really eroded. The most common paid term from a general contractor to a subcontractor is pay-when-paid. And sometimes it’s worse. Sometimes it’s paid-if-paid. And sometimes it’s both.
Lisa: I’m not sure I understand the pay-when-pay or paid-if-paid, and how it impacts cash flow. Can you explain this a bit?
Brent: I can. In the construction industry, you’re typically either a general contractor and we’ll refer to that as a GC, you’ll hear that acronym over and over. The general contractor actually works for the project owner or the developer. Or you are a subcontractor that actually works for the general contractor. So let’s look at this from the perspective of a subcontract. And Lisa let’s pretend that you are the sub to a general contractor on a job and you have a paid term that is pay-when-pay plus 10 days. As the subcontractor, you start the job by buying your materials, your supplies, and you deliver them to the project site. You gotta work you perform that work, and you invoice monthly for labor in the building supplies used in that month. Now, this is called progress billing and you see it on just about every single construction project. Okay, so the GC is going to get your invoice, they’re going to collect the invoices of all the subs on the particular project, and they’re going to merge them into one invoice to the owner. Now, the GC has a contract with the owner that says that he will be paid within 45 days of submitting that invoice. So let’s look at this at a little more granular level. So, Lisa, you’ve delivered your invoice to the GC on the 20th of each month for a 30-day period. And the 20th of each month is pretty standard in the construction industry. Now let’s say it takes the GC 30 days to collect all the invoices, including yours, to inspect the work. And in most cases, the owner is going to expect the GC to look at that work, and inspect the work before he approves that invoice. Now, once he’s inspected that work, he’s going to deliver that invoice to the owner. So again, it takes the GC 30 days to do all of that. And it can take more than 30 days if the invoices are not correct. If the invoices are not correct, you start the clock over again. So by the time the GC sends an invoice to the owner, you’ve already had, you’re already out 30 days from the date of the invoice. Now, the owner pays the GC in the term that they had agreed to and that’s 45 days, and the GC gets another 10 days to get the funds in from the owner, get them in his bank, and then send them to you. So let’s add this up. So it’s 30 days for you to get your invoice or your invoice to the owner from the GC. GC gets another 45 days then they get another 10 days to get the money to you. So you are out a minimum of 85 days from the date of that invoice.
Now I’m going to compound this. In the construction industry. There are typically multiple tiers of subcontractors on a job. So in the situation I described, you are the tier-one subcontractor. Let’s say you have a subcontractor underneath you and that’s a tier two sub and you basically flowed down to your subcontractor the exact same terms that you signed up to, which is what you should do. So now when you get paid in 85 days, you have 10 days to pay your sub. So now the tier-two sub is out a minimum of 95 days before they get paid. And, to be fair, sometimes there are three and four-tiers of subs. So as a sub in general, you can be out of pocket for your payroll and your expenses for well over 100 days. And if this doesn’t throw up a red flag for you, then let this be the red flag… that is a monstrous negative cash flow for you on your job.
2. Out-of-Pocket Expenses
Lisa: You also mentioned that there was a second reason that had to do with out-of-pocket expenses.
Brent: So that’s correct. And the out-of-pocket expenses actually do go hand in hand with the pay term. But in the construction industry, you’re building things. And these things are made from concrete, brick, wood, steel, glass, and they’re just many, many, many more components – drywall I mean, you could go on and own. And these items are very expensive items. And there can be considerable quantities. Think about a skyscraper. That’s multiple, multiple subs, but think about the materials and supplies that have to go in to build that. So when you, the sub, purchase these items for your job, they’re called cost of goods sold, and they show up that way on your P&L. So these cost of goods sold for the supplies can be as much as 50 to 70% of your monthly invoice, depending on the type of job. Now, I’ll diversify a little bit here and come back to it. But I want to add that, and this makes sense in terms of the supplies and materials – winning in construction is a game that’s about productivity. You have to constantly be making progress against your schedule. In fact, all these jobs have schedules and they mandate that you keep up with the schedule and if you don’t, you know, if you fall behind on schedule, you could be looking at liquidated damages, or even be kicked off the job. So to keep the productivity up, you’ve got to keep those supplies very near, or they’ve got to actually be on the job site. And they have to be ready to be used when you need them. Now, to be fair, some GCs will allow you to bill for a portion of your supplies upfront and those are the ones you want to work for. However, most will not and many will not even pay you anything for the supplies until they had been incorporated into the structure.
For example, you’re the subcontractor, Lisa, and you buy 100 windows, and you have them on-site ready to install. You can’t buy 50 and think “Okay, I’ve got to order another 50.” A lot of times there’s lead time for these supplies. So you’ve ordered these windows, you have on the job site, and you’ve already paid for those out of your pocket. But you cannot invoice those until you actually put that window in place. So now you have spent your cash before the job starts. And using an example I gave you previously in terms of pay term, you may not get paid for 85, 95, 100 days. That compounds your cash flow to say the least. So it means you’ve got all these expenses that are out of pocket that you paid for. And then ultimately, you’ve got to float all those expenses until you get paid.
How Do Construction Companies Survive?
Lisa: So how do any of these construction firms make it?
Brent: Well, that’s a broad question. There are a lot of ingredients that go into success. I mentioned a couple of them and but before I dive into it, I will tell you, in the construction business you’ve got to have a little bit of luck. If you think about construction, you’re working outside, you’ve got the weather, you’ve got a huge supply chain, and you’re working around and behind and with a ton of other subcontractors. And sometimes your performing your work means the other subcontractor in front of us has to get their’s done. But first I’ll say and I’ll repeat myself and I can’t say it enough – without a plan without a direction you resemble an amoeba, you have no head you have no tail, you have no direction, and it will often lead to failure. The business plan includes many, many components but one of the components is cash flow – understanding what your cash flow needs are for your firm and for each and every job that you are lucky enough to win and to be a part of. So cash flow has to be known at the level of the company as a whole and down to the job level. Knowing these cashflow needs, and that’s how long it takes basically job to get a job positive and, and how much cash you need to bridge that. But knowing this, you can obtain a source of capital to cover those negative cash flow gaps. This capital can come from traditional lenders like a bank, or nontraditional lenders, like a company like ours: CapitalPlus Financial Services. We’re a receivables factoring company. We basically buy the receivables. The day they invoice, we give them up to 80% of those funds on day one and allow them to make their payroll and even to help fund other jobs. And what we haven’t talked about is: what about the jobs that you’re going to bid on? Where does that cash come from when you’re already in a net negative cash flow on most of the jobs you’re running? And that’s just part of construction.
Secondly, I would tell you is, we’re talking about pay terms, we’re talking about having to buy things out of pocket, all these things are defined in your contract. You need to be a strong negotiator when it comes to terms and conditions in your contract. You know, the answer is always no if you don’t ask the question. So you, as a subcontractor, have to be willing to go toe-to-toe to a degree and ask the general contractor for more reasonable terms, or be willing to walk. If you can’t get the terms that you need to put you in a relatively good positive cash flow position. Think about walking, you unknowingly go out in the woods and step into a bear trap, right? So why would you step into a project that is going to hurt your business, that’s going to clamp down on your business? Do not allow these owners and GCs to push all of the risk to you. And going to tell you, having been in the business 37 years, they are going to push all risk, push all cash flow burden down to you. I hate to say it, but that’s their job, that’s that’s what they do to protect their companies. But they’re expecting you, if you’re a good businessman or a good businesswoman, they’re expecting you to push back. I’ve hired a bunch of subcontractors in my life and I’ve pushed down pay when paid terms all the time. And the ones that just took it swallowed it, didn’t push back, I have to tell you, I’ve at times questioned how good businessmen or women they were. So the general contractors, or the subcontractors that you may be working for as a tier-two subcontractor, they’re expecting you to push back on this and other owners, on difficult terms that put you at risk. So what I would say is negotiate, do good work, build a great reputation in your industry. When you have a good reputation industry, GCs want to come to you, they want you to work for them. And then you leverage that reputation to get the terms you can live with.
Lastly, I’m going to tell the owners of construction firms, to manage your supply chain, and the costs in your business to meet that plan. I go back to the plan – your plan should have a financial plan. I need to know what my top line needs to be, what my expenses are, my cash flow is… all those things to be able to run the business and make the margins that I am planning for. So, be willing to push down the same pay term, same terms, and conditions to your suppliers where possible. Do not become the bank for them. I mean, if you’re out 90 days, and your subs who are a part of that invoice, you pay them in 30 you become their bank. And it just makes no sense for you to do it.
As you get down chain, tier-two, tier-three suppliers, sometimes those guys are going to be really specialty suppliers. They’re not going to be big enough to float 90 days. And you might have to pay them out of pocket. I mean, that’s just part of the game as well. But you can’t pay all your subs in 30 days and you’re waiting to get paid 90. So I would tell you: pay your bills, have good credit, have a good reputation, use that reputation, to get good suppliers, and leverage the best terms you can get with your customers. And that’s the best way to manage your cash flow issues in construction.
Lisa: Well, Brent, thank you so much. This has been great information. We appreciate your insight and your time today. So thank you.
Brent: Well, Lisa, thank you again, I hope that the message is well received. And, you know, there are a lot of really good contractors out there that know the business and do it right. And hopefully, this will help some of those that may be entering the business. I would remind everyone that there are a handful of capital sources out there that help you to bridge your negative cash flow on these jobs. You know, one is certainly the bank, as a traditional lender. Another avenue is factoring. At CapitalPlus we’ve been doing, we’ve been factoring to the construction industry solely for over 20 years, we’ve put over a billion dollars in the hands of contractors in the last 20 years to help them to float their projects, not only to help them float their projects, but buy the materials and supplies for their next project. So I would just say always know what your cash flow is and have a capital source in place for every day, especially for a rainy day. So thank you again, Lisa. I look forward to talking to you soon.
Lisa: Great. If listeners would like more information you can reach our team through Capitalplus.com. Thanks for listening to this episode of Construction Insider and if you found our podcast helpful, check out the next one in our series, the impact of COVID 19 on the construction industry. Until next time, be well.
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