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Taking the time to thoroughly vet subcontractors before hire can go a long way in protecting you and your business from catastrophic loss.

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Six Steps Construction Companies Can Take to Avoid High-Risk Subcontractors

  • Mike Burton
  • 10/26/2018

As the economy continues to expand, more contractors find themselves operating at or near full capacity. The downside to this trend is a more limited pool of qualified subcontractors with the capacity to take on projects. In this environment, it may be necessary to branch out and engage with new, less experienced subcontractors.

For organizations that are looking to start subcontracting work, or have only limited systems in place for selecting qualified subcontractors, now is the time to take a look at your process. You will find that implementing a comprehensive subcontractor prequalification process can act as a firewall to protect both yourself and your clients from catastrophic loss.

Similar to how banks or surety-bond companies evaluate a potential borrower’s credit worthiness, general contractors rely on this process to determine if potential subcontractors meet defined benchmarks for financial stability, experience, and legal and safety records.

Subcontractor non-performance can have long and wide-reaching implications, including the immediate financial liability of bringing in a replacement subcontractor, higher insurance and bond rates for future projects, and the loss of valued customers.

The recently enacted California Assembly Bill (AB) 1701 adds even greater potential financial liability for contractors in that state. Effective January 1, 2018, general contractors on private construction projects in California are liable for any unpaid wages and fringe benefits owed to employees of subcontractors, even if the general contractor has made all contractual payments to the subcontractor. But regardless of what state you operate in, choosing a worthy subcontractor is a critical practice.

We recommend that each subcontractor be subject to an initial review, and then annual reviews thereafter to ensure standards are maintained. These key steps and best practices for building an effective prequalification help to identify the risks of working with potential subcontractors, but also quantify risk levels to allow for comparison with benchmarks and other companies in the industry.

Step 1: Understand the need for prequalification

There are four key variables to consider when identifying projects that require prequalification:

  • Bonding
  • Scope of work
  • Contract value
  • Overall project risk score based on experience with owner and type of work

Non-bonded subcontractors require far more extensive vetting than bonded subcontractors due to the added security that bonded subcontractors provide. A bonded subcontractor is indemnified by an insurance company against losses arising from potential non-performance.

Subcontractor default insurance provides an alternative to surety bonds for larger general contractors with greater risk tolerance and more sophisticated management and accounting teams. These policies generally carry high deductibles that are not cost effective for smaller contractors.

Step 2: Require a prequalification package

A thorough prequalification package will help you to vet subcontractors prior to hire and should include the following essentials:

  • Company information form completed by the subcontractor, including information on owners, performance history, license information, safety history, and a range of references
  • Financial statements from the past two fiscal years — these should be audited or reviewed by a reputable CPA firm
  • Insurance certificates detailing coverage — these should be reviewed by your insurance carrier
  • Letter of good standing from labor unions
  • Supporting documentation for safety history, including OSHA forms 300A and 300, and EMR verification from worker’s compensation carrier

As a best practice, consider doing an annual review of updated information from all prequalified subcontractors to ensure there has not been a material degradation in the company’s health and financial position.

Step 3: Evaluate references and overall character

Take the time to consider a diverse mixture of references, including clients, referral sources, and partnering contractors. By evaluating references, you can get a feel for the overall reputation of the company and a history of legal issues. Be on the lookout for any indications that the company is difficult to work with. Consider the quality and duration of relationships the subcontractor has formed. Likewise, take the time to obtain an overall impression of their culture and values.

Step 4: Financial evaluation

As a best practice, a CFO or individual with sufficient knowledge of contractor financial statements should take the lead throughout the financial evaluation process. Audited or reviewed financial statements prepared by an independent CPA for multiple years can provide important insights into the financial health and stability of potential subcontractors. The statements should be prepared by a reputable CPA firm that has a good relationship with the banking and surety industries.

Review key ratios on the income statement, balance sheet, and statement of cash flows for any unusual or concerning trends in profitability or liquidity. For subcontractors that are significantly under-billed, additional understanding may be necessary to ensure the under-billings are not from claims, unapproved change orders, or aggressive estimates. Under-billings may also be an indication of poor cash management and additional default risk. Be sure to review backlog levels in relation to working capital and available bank financing to identify candidates that may be over-extended or at risk of running out of cash as projects ramp up.

The footnote disclosures, which are often overlooked, contain critical information regarding transactions with related parties, backlog, debt terms and covenants, and claims and contingencies. Significant changes in contract estimates (profit fade) present a more complete picture of the entity’s financial position and operations.

Additionally, review the lien history of the subcontractor, and utilize credit reporting resources such as Dun and Bradstreet for indications of past credit problems.

Step 5: Evaluate project and performance history

Consider if the subcontractor’s portfolio of completed contracts and qualifications demonstrates a track record of success in similar types of work and project size. Extra effort should be made to verify all stated qualifications directly with references and reliable industry contacts.

Based on discussions with management and a thorough review of internal documentation, assess the adequacy of the systems and controls used by the subcontractor to maintain standards for quality and timely project execution. Companies with a well-designed organizational structure, which have developed over a long period of time, are better positioned to keep jobs staffed properly and are more likely to complete work on schedule.

An in-depth review should be performed for safety records, including workers compensation rates and the adequacy of the contractor’s safety training and monitoring program.

Step 6: Evaluate contract provisions

Work with an attorney to develop a standard subcontractor agreement to ensure your documentation is up to date with current construction and state law and contains adequate protections. Also, consider having your attorney review any unusual, complex, or poorly defined language requested by a subcontractor.

Based on the results of the financial evaluation, assess the overall level of financial risk to determine whether or not there is a need for additional requirements or provisions to mitigate the subcontractor’s default risk. For higher-risk subcontractors, consider requiring personal guarantees from the owners. If possible, request more restrictive payment terms. These may include higher retention, joint checks for material suppliers, and certified payroll or proof of payment of benefits to unions.

Based on applicable state laws for your company, like the recently enacted AB 1701 in California, consider adding additional provisions to guard against unpaid payroll liabilities, including:

  • Audit provision requiring submission of payroll records on a regular basis
  • Indemnity provision to protect against claims arising from subcontractor’s employees
  • Personal guarantees from owners
  • Payment bond and/or letter of credit to satisfy claims
  • Withholding and back charge provision to allow hold or charge back of disputed amounts or claims
  • Payment verification system requiring the subcontractor’s employees and third parties entitled to recover benefit contributions to acknowledge payment

Let’s face it — in the construction industry, time is money. And the constant pressure to meet project deadlines requires quick decision making. However, taking shortcuts without vetting subcontractors risks not only your reputation but the solvency of your business. If you invest the time to perform your due diligence, you can gain a trusted partner who will help solidify your standing in the industry and bring you closer to your strategic and financial goals.

How we can help

CLA construction professionals keep a close watch over current issues so that you don’t have to. As a national firm, we track general trends across the country because we understand that each construction company’s contracts and books of business are different. And, thanks to our consultants’ deep industry knowledge, we are able to review your controls and operations and can offer valuable resources.