Mitigate Subcontractor Risk
BY Sean Rizer
As the calendar turns to spring, paving season is right around the corner. Backlog is feverishly growing as contractors set goals and expectations for the 2021 construction season. Most paving companies hire subcontractors throughout the season. Risk mitigation is a daily responsibility for all contractors and subcontractor prequalification is a key step to risk mitigation and ensuring projects are completed on time, on budget and safely.
For this article, we will focus on certain factors that as a prime contractor, it is critical to get right when evaluating subcontractors:
- Subcontractor Risk Factors
- Scope Capabilities
- Geographic Reach
- Current Backlog/Schedule
- Business Continuity Plan/Longevity of Existence
- Mitigation Strategies
- Credit References
- Financial Benchmarking
- Joint Checks or Direct Supplier Relationships
As a prime contractor sending out a request for proposal (RFP) from subcontractors, you must ensure you are soliciting contractors who are qualified to perform the work required.
As companies grow, their skill sets change. They might have started out as a driveway paving company then evolved into paving small parking lots and eventually getting into large new construction projects. Somewhere in the growth cycle, a prime contractor or customer took a chance to help that subcontractor perform a project that might have been outside its historical comfort zone.
As you evaluate the skill set of the subcontractor, learn the history of what types of projects they have performed as well as if there has been any turnover in key operational positions. For instance, if it is a paving company with one crew and the crew foreperson retired last year and there is a new foreperson on the crew, would that impact you selecting them to work on a project?
For prime contractors who travel, a key decision to make is whether to take with you a subcontractor that you are familiar with or to enter into a new relationship with a subcontractor you have never worked with before.
Depending on the location, the local labor market is likely different than the home base labor market and factoring those rates into the bid are important to consider. Further, understanding the dynamics of union and nonunion labor in the local market is critical; depending on the market, union or nonunion labor may be customary and one type of labor may not be successful in that market.
Added costs to the job such as out-of-pocket travel can increase costs of taking a subcontractor with you. If you have confidence in the quality of the subcontractor’s skill set, does the travel cost potentially save money down the road by not having to worry about subcontractor failure?
Contractor failure to perform/complete work occurs more frequently during an economic uptick than a downturn. The reason being, it is easier to scale back and reduce costs than it is to find a new crew to come work. Company culture is important and not about just finding anyone to work. For companies that do not regularly project their committed crew hours/days, winning work can create a scheduling problem where there are more jobs that need to be performed than the crews have time to do.
For instance, if a company has 1,000 crew labor hours available given its current work force, the company needs to make sure its jobs are staggered in the schedule so bottlenecks don’t occur where crews need to be at the same place at the same time. It is nearly impossible for most companies to forecast by project when the project will start and finish, so using averages is best when evaluating whether or not a company has labor capacity to take on new projects depending on when the project needs to be completed. For evaluating subcontractors, knowing what capacity and flexibility they have in the schedule allows the prime contractor additional insight to whether the subcontractor can meet the schedule or not.
Business Continuity Plan/Longevity of Existence
How often is the phrase, “we’ve used that sub forever” said around the office? It is common to get comfortable with certain subcontractors, knowing their capabilities and how they work with your company. Although a long history is a positive factor in prequalifying a subcontractor, it is not the only factor to be used and long-term relationships should be under review routinely.
Companies that have been in business for several years can get to a point where ownership is not as involved as it used to be. This can be challenging to identify as an outsider/prime contractor but understanding the tone at the top can inform outsiders a great deal about what is occurring within the organization.
For companies that have not been in business for a long time, prime contractors should do an elevated level of diligence to ensure the contractor understands the three other risk factors previously discussed. Often, new companies are started by key employees transitioning from a larger company to start their own operation.
People who are great at operations do not always make the strongest business owners, and startup businesses usually do not have the financial resources for other key management team members to oversee the business side of the company.
It is possible for profitable companies to go out of business due to financial mismanagement and not understanding the working capital needed to run a paving company or being an asphalt supplier.
Understanding subcontractor risk factors and going through a detailed prequalification process may seem like a lot of work on the front end but may save you significantly on the back end by choosing the correct subcontractor who is capable of performing the work.
Obtaining information as close to “real time” as possible will allow prime contractors to make the most meaningful evaluation of the subcontractor’s ability to complete the project on time and on budget.
Credit references are often done at the start of a new relationship and then never again. While it should be an important part of the prequalification process, prime contractors should continue to evaluate the credit worthiness of their subcontractors to ensure they are paying their suppliers.
Financial benchmarking is a best practice recommendation. Many companies are hesitant to share financial information. If contractors require outside CPA financial statements as part of their prequalification, be advised that those statements are at a point in time and can very quickly become stale information regarding the financial position of the company. Some key financial ratios to consider are working capital, debt to equity, line of credit availability, net profit and backlog sales.
Joint checks are written from the prime contractor payable to the subcontractor and its supplier. The purpose of the joint check is to ensure the supplier is being paid timely and in full. Joint checks help mitigate the risk of a lien or bond claim being filed on the project ensuring all project stakeholders are paid.
Surety bonds are frequently correlated to public works as they are a requirement on most public work projects. Prime contractors, as a safeguard to the project, have the option of bonding subcontractors via payment and performance bonds. Surety bonds vary depending on the locality so if you do not currently have a relationship with a surety bond agent, it would be recommended to develop a working association.
In the current environment we operate in, a solid subcontractor can be what helps set a contractor apart from the competition en route to a successful contract.
Sean Rizer is the CFO for Harding Group, Indianapolis, Indiana, which performs asphalt services, supplies hot mix asphalt and provides dump truck transportation. Prior to joining Harding Group, Rizer spent over 10 years in public accounting, providing operational and transactional consulting. He graduated from Valparaiso University with a bachelor’s degree in both accounting and finance.