Surety Bond Quarterly Professionals in Surety Bonding
By Kevin Hamernik of BKD
Working with a company struggling or bordering on the edge of insolvency is difficult enough, but any seasoned turnaround professional who has worked with construction companies knows this industry presents additional, unique challenges. Why? Although there are many reasons, this article will focus on examining five major elements.
1. Lien Impacts
In general, contractors, subcontractors, and suppliers to prime contractors, subcontractors, laborers, and equipment lessors who have delivered goods or services to a project for the improvement of real estate may file a mechanic’s lien against the project, subject to certain conditions so long as the notice and filing of the lien are timely. The lien often provides notice to the general contractor (GC) if the company is a subcontractor or to the project owner in the event the company is the GC. And once that genie is out of the bottle, it is very difficult to put it back in. Practically, the issue is no longer a two-party issue but becomes a three-party (or more) matter, with the company’s customer now meaningfully engaging in discussions.
A lien often results in a loss of confidence and other relational issues, as well as increased time and resources that will need to be dedicated to managing relationships. In addition, the consequences can and will affect receipt of payment for work performed in the case of the GC/subcontractor or likely will create issues for the owner with its lender, who will require the property to remain free of liens other than theirs (or earlier approved liens) and otherwise burden the transfer of the property at some later date. As described below, there is some good news for the owner (and GC/subcontractor): they have remedies and actions they can take. For the company, however, things are likely about to go from bad to worse.
2. Customer Remedies
Whether the company is the project owner or the GC/subcontractor, to ensure the project advances, it needs to see that the parties doing the work “down the supply chain” are getting paid and, by payment and satisfaction, any liens filed for nonpayment are released. Commonly, this is accomplished by control of payment and redirection from the nonpaying or insolvent company or through joint check arrangements, which require the company to endorse payment to its vendor(s) to ensure the vendor(s) receives payment. First, this change of payment process often delays payment and has an immediate, adverse effect on cash flow, as the company can no longer use the benefit of positive working capital implications arising from receiving and using cash for a period of days or weeks prior to paying invoices, trade terms, or float.1
Almost all public jobs and many private projects require performance bonds. Should the project owner call upon the bond, and the bonding company be required to engage, this will add additional reporting and investment of time. In the best-case scenario, payment of the company’s billings will come through the bonding company only upon its certainty that all suppliers and subcontractors will be paid by using joint checks or, alternatively, after monies are funded into an escrow and after such time as the escrow is administered by the bonding company, ensuring that suppliers and subcontractors are first paid, with only remaining funds turned over to the company.
Some other arrangement might be used, but all are designed to ensure the project is completed and to avoid the filing of liens. Additional holdbacks may result to ensure that any warranty claims made at a later date can be fulfilled or provided for. There is risk; however, that the bonding company will determine the company is no longer capable of performing and managing the work and relets the work to another, substitute party to finish the work instead of the company. Then, the additional costs associated with reletting, plus reserve credits, plus potential warranty reserves, could hold up any payments to the company and would likely erode any remaining profit in the job for the company.2
3. Common Customers–Common Vendors
Construction companies typically maintain low concentrations of both customers and suppliers in each category, relying heavily on those they have. On its very face, that elevates risk, including risk to revenues if the customer’s business changes for the worse or if it elects to shift work to another business partner. Similarly, on the vendor side, alignment with limited suppliers can cause the company to be susceptible to supply chain issues and performance risk.
The turnaround advisor will often review relationships of the company and prioritize or categorize them into a few classes ranging from critical to unnecessary. Degrees and filters may vary, but conceptually the advisor identifies and associates the most critical relationships upon which the core business is reliant to protect them at all expenses. Specifically, on the supplier side, it is not altogether uncommon to categorize vendors according to those the company must ensure are paid on time and those that will not receive payment on time or for some time. The supplier would prefer certain vendors over others and prioritize cash spending to those relationships that are critical.
In a manufacturing environment, for example, this might be easier and lead to cash savings where an alternative supplier might be identified to source goods or an existing relationship might increase their sourcing while holding further orders from another existing vendor that requires a reduction of credit exposure, COD, or COD+. However, in construction, it is possible, or even likely, that the vendors are involved in and found across most or all of the jobs or projects. Naturally, the vendor has leverage across all projects if it is not receiving payments on one project. And finding substitutes to complete work already started is difficult—or impossible—for a variety of reasons, including, but not limited to, the following:
- An alternative vendor’s capacity due to other jobs on which it is presently working
- Geographical proximity
- Concerns about exposures to warranty and quality of work
- The universe of acceptable alternatives may generally be limited compared to, for example, steel providers to a manufacturer.
However, even if it is possible to cherry-pick vendors and payment thereto only where it serves the company by job, return to the issue above about mechanic’s liens. In the next section below, we will explore another reason the common vendor relationship can become problematic.
4. Accrual to Cash Conversions
The mantra in all turnarounds is not only true in construction, but also is more elusive to identify with contractors: cash is king! Percentage of completion (POC) accounting is pervasive in the construction industry. The timing of revenue recognition and billing is not directly sequenced but indirectly correlated, and revenue recognition is altogether based on estimates about the status of project completion.3 Upon examination of the company’s records maintained in the ordinary course of business, one might arrive at incorrect conclusions. A well-prepared job’s work-in-process schedule will report the initial contract amount and estimated costs and margin, costs incurred to date, revenue earned, and margin for the period, reporting year, and life of the contract. Similarly, it will report billings to date, remaining billings, and, by extension, overbilling (or underbilling). What it will most likely not reflect is the outstanding receivables and retainage or the outstanding payables on the job. Only after incorporating these elements and then revisiting remaining costs to be incurred (which will often change upon further scrutiny) can the actual cash profit or loss in the job be determined. After doing so, the jobs can be evaluated at the job level and, in total, at the customer relationship level.
With a little more work, effort, and analysis, the same can be done by common vendor. In a distressed environment, it is critical to be able to communicate whether the job has cash remaining in it or will cause further cash losses and needs to be funded to completion. Although arguably oversimplistic, there are unique times that deciding whether a job is a “go” or “no go” can and will largely come down to this analysis; and only jobs that will realize positive cash will and can be completed.
5. Projection Challenges
In part, playing off the preceding section, the use of POC accounting and the unique nature of progress billings can make preparation of financial projections complex and prove very difficult. Forecasting the income statement at any level of job detail requires many uniquely individual and specific assumptions regarding which and when certain events will occur and about at what times each job will be completed to a finite stage relative to the entire project. There are often many variables, including weather or access to the job site or whether the trade that was required to complete work prior to the company does so on time. In short, the more assumptions required, the greater the likelihood of error. Although it might be easier for jobs already in process or awarded and in the backlog (collectively, the short-term view), it becomes nearly impossible the further out the company attempts to project.
Similarly, projecting a balance sheet (and the statement of cash flows) is uniquely difficult; but even to a greater extent, as mentioned earlier, billings are not directly tied to revenue recognition. Therefore, it is necessary to understand by job the billing terms and when bills can be submitted. Then, the timing of billings and all the potential holdbacks and credits that might arise should be evaluated, as well as stated and historical payment terms. The company often may be limited to billing only at the end of the month, or twice a month, which necessitates considering whether certain work will be completed prior to the billing date to allow it to be billed.
Finally, overbilling/underbilling is a critical component of working capital and heavily influenced by how the jobs mix and time with one another, shifting the overbillings/underbillings accordingly in total and the expected timing of cash flow. Experience suggests that, most often, accurately projecting overbillings/underbillings well beyond three to six months not only is unlikely but also creates a false sense of confidence. Accordingly, it is common to leave these critical balance sheet accounts “flat” over a projected period or otherwise formula-driven using historical relationship; but in doing so, there is an implied concession that the effect on cash flows is not known. This concession could be significant.
With the foregoing challenges, communicating with constituents (banks, sureties, customers, and vendors) and framing projections about future performance and cash needs is that much more difficult, especially in a situation where parties not only expect but also need to tighten expectation gaps and the company is trying to regain credibility. For that reason, the company should clearly communicate the potential shortcomings in assumptions to users and run sensitivity analyses to identify ranges of effect based on such changes to best secure sufficient liquidity and covenants for timing differences.
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Kevin Hamernik leads BKD’s restructuring and special situations team and has more than 25 years of professional experience. Prior to joining BKD, he was an owner and managing member of an Indianapolis firm where he specialized in restructurings and turnarounds, financial and strategic consulting, special situations practices, financial due diligence, transaction support, debt and capital transactions and originations, forensic accounting, and litigation support. He is a member of the American Institute of CPAs and Indiana CPA Society and is a Certified Insolvency and Restructuring Advisor (CIRA). Hamernik can be reached at [email protected] or at 317.383.4000.
This information was written by qualified, experienced BKD professionals, but applying this information to your particular situation requires careful consideration of your specific facts and circumstances. Consult your advisor or legal counsel before acting on any matter covered in this update.
Article reprinted with permission from BKD CPAs & Advisors, bkd.com. All rights reserved.
End Notes
1 Red flag #1: Many, if not most, contractors use AIA contracts for submitting invoices; and most, if not all, such contracts require an attestation by the submitting party that all expenses incurred in connection with that billing have been paid to date. Parties should proceed with caution and take note of these representations and the potential implication of creating personal liability by the signor.
2 Red flag #2: When these deals go south and if there is not enough profit and cash in the job to pay all the costs, the sureties will be looking to officer and owner and other indemnitors, shifting what was once a corporate debt to an individual obligation. A bankruptcy filing for the company will not provide these individuals with protection.
3 This article intentionally stops short of addressing the inherent issues that arise here and opportunities for error or misrepresentation in making estimates.
