In heavy construction, everybody works hard, everybody wants to win, and, at least in the past few years, everybody has work. So why do some contractors do well and others dry up and blow away?
The specifics of that answer vary depending on whether you’re a start up operation, a medium-size company or a multi-million dollar firm. In almost every case external events don’t sink most failed contractors, but rather wishful thinking, failure to face the “brutal facts,” as Jim Collins, author of “Good To Great,” puts it. This includes failure to plan, thinking time in the field is more important than time in the office and the failure to accurately assess your own strengths and weaknesses as a manager and the strengths and weaknesses of your employees and your customers.
Reach exceeds grasp
Bigger may be better when you’re making widgets, but when you’re moving dirt or paving roads, growth for the sake of growth is dangerous. Matt Klimczak, director of underwriting for The Surety & Fidelity Association of America says “A surety underwriter would ask, ‘How are you going to do this? Are you just taking on jobs for the sake of top line growth? Is there a game plan to address the additional costs?'”
In addition to having a plan and a rationale for your growth, working capital needs are critical, Klimczak says. “Do you have the cash on hand to pay your bills on a weekly basis? Will cash flow support the project? Do you have bank credit in the event of cash needs? If not, you’re probably better off not taking on that additional obligation.”
The brain drain
In addition to needing the financial wherewithal, emerging contractors have to realize that they may not have enough good people to take on big new jobs – especially supervisors, says Sam Carradine, director of development and diversity for The Surety & Fidelity Association of America. A contractor just starting out may know how to execute a certain job, but unless he has a supervisor who is equally knowledgeable, he’ll have to factor in training time and the loss of productivity that comes when new hires are learning on the job.
New companies are often training grounds for supervisors, Carradine says, which exacerbates the problem. “As soon as they get one trained the big companies come after them and offer them better pay, so there’s always a shortage of good people,” he says.
Stranger in town
Growth outside a contractor’s core competency or geographic area is also risky. When you’re hungry for work you may be tempted to take a chance on a type of job you’ve never done before. Many contractors may think they can figure out what they don’t know on technical issues. But time spent problem solving or learning a new application is expensive. And in a thin-margin business like construction this kind of downtime can quickly erode a job’s profits.
Chasing dollars from out of state or in another region also brings a new set of risks and expenses, says Carradine. The outside contractor won’t know the local suppliers, labor market, codes, taxes and regulations as well as the local contractors. They may fail to adequately budget for transportation costs. Local politics can sometimes throw up barriers as well, and the area’s established contractors aren’t going to greet you with open arms.
Partner for protection
Despite the dangers of excessive growth, Carradine and Klimczak say there are well-proven strategies for handling big opportunities when they come along. One of the most popular strategies is to find a partner. Split the financial risks of a big job with a subcontractor or group of subcontractors and structure the job as a joint venture. If the job involves technology or applications outside of your core competency, partner with a sub that specializes in this area. If the proposed job takes you away from your natural geographic reach, partner with a local sub or contractor who knows the area.
This is essential for small contractors trying to build up their business, but it’s also good advice for contractors of any size. Klimczak says he regularly sees multi-million dollar construction firms doing just this. Partnering is particularly beneficial on jobs that require multiple disciplines.
Don’t be a dinosaur
Carradine says emerging contractors also need think about partnering as more than just a job-to-job strategy, but as a model for the permanent structure of their company. “The growth model that’s most prevalent in construction has to do with increased use of subcontractors,” he says. “Some people think the growth model is to move from your specialty trade to general contractor, but I try to discourage that notion.
“If you’re in the trades, you grow by becoming a first tier trade and sub out the second tier trades,” Carradine says. “In this industry today you do not grow by increasing self performance. Just the opposite. The risk is being shifted down more. Nobody wants to take the risk on everything. Aspiring to be a dinosaur is not a good model.”
Construction is different
Most entrepreneurs who start their own construction companies bring to it deep knowledge and experience in their craft. The one skill set they often lack, however, is accounting and finance. And construction company accounting differs from any other type of accounting, turning this aspect of the business into a double risk.
“In most companies the financial statement is a retrospective view of what has occurred, Klimczak says. “On a contractor’s financial statement, a good portion of its strength is prospective because it’s based on the profitability of uncompleted work. Thus cost systems must be appropriate in order for accountants, banks, bonding companies and sometimes even the contractor to know that the job is going well and if the cost systems are adequate.”
Weather delays, increases in material costs and other unknowns further cloud this all-important assessment. You could be working hard, making payroll and going broke and not know it for six months.
“Contracting is a difficult profession in that you have to bid for and commit to your final price before any construction is initiated,” Klimczak says. “In most businesses you know what your costs and overhead are and price your product accordingly.”
Leading of the band
In sizing up an owner’s management ability Klimczak says he looks for discipline, controls and organizational skill. “How are they assessing their projects and people? Do they understand the need for a good accountant and attorney? Do they have good banking relationships? Do they have access to funds to solve problems? I think of management as an orchestra leader who brings all these elements together.”
The ability to understand your limitations is also important. “I want some sense from the contractor that he understands what he doesn’t know, or at least acknowledges what he doesn’t know,” Carradine says. “And if you’re a good manager you’ll have a game plan as to how you’re going to acquire that knowledge.”
Do you care?
Passion and commitment to the business likewise indicate something about your future as a manager, Klimczak says. You don’t want contractors who might easily get distracted by boats, exotic sports cars or race horses, he says. And you want somebody who is a comfortable in public, not a hermit.
“Contractors are part of the community. They can’t be hiding behind their desk or avoiding conflicts,” Klimczak says. “The more you get out in front of people the more business you get, the better you’re thought of, the more subcontractors want to work for you. It has a snowball effect. Surety companies look for that kind of belief in the organization – positive attitudes and optimism.”
Bonding makes you better
While some contractors might lump bonding into the same basket as banking, permits and boring indoor work, the process of acquiring a bond can instead be a thorough means of evaluating your company and ferreting out weaknesses.
“Surety underwriting is an affirmation of the quality of a company’s management,” Carradine says. “The prequalification process is a tremendous tool for business planning. It will tell you in a conservative way what the experts think about how you should grow and what the structure of your company should be.”
When big firms go bad
While small startup firms are inherently risky at first, older, multi-million dollar construction companies sometimes fail as well. Some of the reasons are the same, but there are also problems unique to the big players.
FMI, the construction management consultant company, recently completed a study of failure in firms over $250 million. The study, titled “Why Contractors Fail: A Causal Analysis of Large Contractor Bankruptcies,” found that in most cases there was not a single event or job that caused the failure. “What we learned is that there are a lot of interrelated things that happen all at once,” says Hugh Rice, FMI’s chairman. “It was rare that a single event or issue pushed the company over the edge.”
Once this swarm of small problems coalesces into one big problem, the company enters what the FMI study ominously calls the “Bankruptcy Doom Loop.” Regardless of size, when a company enters this death spiral, it’s almost impossible to recover. You can’t just declare bankruptcy, wipe the slate clean and start over again, Rice says. “You have to finish all that work. Sometimes the claims will go on for years. How much money can you lose on a single job? The answer is all you’ve got.”
People power
The second reason construction companies rarely start over is that the organization falls apart. “If things go sour, the good people leave and get jobs somewhere else,” Rice says. And in a people-intensive business, customers don’t want to do business with people who don’t have the talent or financial strength.
FMI also found that failed companies often did not have enough talent in the ranks of middle management: supervisors, project managers, superintendents and estimators. “It’s not just the executive suite,” Rice says, “but the people who actually run the work. Construction is unique in that huge amounts of responsibility are managed by people pretty far down in the organization.”
Having an experienced group of managers who have worked together a long time is critical, Rice says. Going out and winning a bid and then hiring the people after the fact is one of the worst things you can do.
Speaking truth to power
The construction business poses many dilemmas, perhaps none more acute than the difference between self-confidence and overconfidence and the tension between number crunchers and operations-oriented entrepreneurs.
Probably the biggest conundrum, Rice says, is you need a hard charging, risk-tolerant entrepreneur to get a construction company up and running, but this personality type can also let their ego and a sense of invincibility get in the way of common sense. “Then sometimes you end up taking risks you shouldn’t.”
One solution as an owner is to make sure you have strong financial partners who can keep you honest. “All too often the people in the executive suite need a naysayer,” Rice says. They need a devil’s advocate, somebody who can get their attention. Sometimes that’s the financial person and sometimes it’s not. But there needs to be a person who has no fear of reprisal.”
Discipline with dollars
Another safeguard is to put rigorous financial systems in place. “You have to have good data and know where you are and know how the jobs are doing and how to respond,” Rice says.
By these criteria most construction companies are not financed appropriately, Rice says. Most define their financial capacity based on how much bonding they can get and that may not be the right measure. “Large debt doesn’t work in construction companies,” Rice says. “It’s a volatile business, it’s seasonal, it’s cyclical. And they can’t handle large amounts of debt even though other businesses can. So it’s how you set up the capital structure, the mix between debt and equity and how much of your money is in working capital and cash versus tied up in non-liquid assets.”
Contractors who are more risk tolerant and less conservative would argue that tying up cash in reserves might reduce their ability to go after more jobs. But Rice has an easy answer for that: “Which is more important – having a 50-percent return and potentially going out of business, or having a 30-percent return and living to fight another day?”
Understanding the business side of construction is critical for owners and entrepreneurs. “People forget that the business comes first and the project second,” Rice says. “You can be a great project manager but not be a good business person. And when companies reach a certain size they become significant businesses and managing the financial affairs of the business gets to be quite important.”
Succession planning
Even the best run construction company can run into serious problems when time comes for a change at the top. Whether this change is retirement or the sudden death or illness of the owner, whether it’s a big company or a small one, the risk is considerable.
For a retiring owner, a proper succession plan may require five to 10 years of preparation, Rice says. “Just because you have a son or daughter doesn’t mean they’re the best person to run the business when you’re done with it. Companies get into significant difficulties because of that.”
There is a right way and a wrong way to bring kids into the business and get them trained and positioned for success. “The answer is to treat them like anybody else,” Rice says. “Run them through a training program and make sure they have a chance to learn the entire business from the ground up. They shouldn’t just come to work and get to be the CEO in two weeks. The real question is not so much the training but do they have basic skill sets, qualifications and aptitude to run a construction company successfully. Training is pretty straightforward if you have the right ingredients.”
For small or start-up construction firms, most bonding companies will likewise need to see a succession plan, even if it’s only on an emergency basis.
“Bonding companies want to have some assurance that the contractor’s obligations are going to be met,” says Klimczak. One solution is life insurance on the owner. “That gives the company some problem-solving dollars in the short term,” he says. Another solution is to forge an agreement with another contractor. In this scenario if something should happen to an owner the other contractor, for a sum of money, would agree to come in and complete the work.
“If there isn’t a continuity plan in existence, a bonding company will usually ask that the contractor meet with his lawyer and develop such a plan,” he says.
REFERENCED RESOURCES
- Good to Great: Why Some Companies Make the Leap and Others Don’t, by Jim Collins. This book began as a university research project, but it’s highly readable and considered one of the most important management books of the last 10 years. It analyzes a handful of companies that beat the average returns of the stock market more than seven fold over 15 years and illuminates why they were so successful.
- Why Do Contractors Fail? Surety Bonds Provide Prevention & Protection. Free download at the Surety Information Office: www.sio.org. Also check out the website of The Surety & Fidelity Association of America, www.surety.org.
- Why Contractors Fail: A Causal Analysis of Large Contractor Bankruptcies. FMI’s in depth study of the causes of large contractor bankruptcies, www.fminet.com.
