Last week we reviewed several stories about homeowners who lost money to unscrupulous contractors.

In that post, we discussed all the ways you can research suppliers to be sure you are working with a reputable contractor.  One of the other observations I had from those articles is how poorly payments were managed by these homeowners.

Poor payment management is actually not as uncommon as one might think.  I recall a residential Client I had several years ago who found herself upside down on a whole house remodel.

The project was in northern New Jersey.  My Client and her husband had hired a contractor that was recommended by a colleague.  The contractor quoted them more than $450,000 to remodel their kitchen and baths, build an addition, replace the roof, and extend their porch.

The couple came to me 8 months into their project because the progress had been very slow.  When I dug deeper, I learned that they had already given the contractor $380,000 of the $450,000.  Upon close inspection, the work was less than half-way done and the contractor had left materials and debris strewn around their property for weeks without returning to work.

When I asked what the $380,000 was supposed to cover, I was told they had made several payments over time and that the contractor simply said these payments were for paying his guys and buying material.  When I asked about a ledger or some kind of payment record, the couple had to contact their bank for copies of the checks.

In other words, they made payments to the contractor without knowing what these payments were for.  They had no invoices to show for the payments and they kept no records of payments.

So in light of my personal experience with this couple and the faux pas of the families we read about last week, I wanted to cover a few best practices for managing payments in construction.

Deposits and upfront payments

One of the nuances between residential and commercial construction is that residential contractors are smaller and typically have less access to capital, so it is quite common for them to request payments up front.  In commercial construction, upfront payments are almost never given.  This varies from one country to another, but in the US, all payments for commercial construction are made in arrears.

In residential construction, most suppliers are not able to buy materials and pay for labor without a deposit, so we need to acknowledge that this is a condition of the market and we need a strategy for managing deposits.

Up-front payments are a huge risk for homeowner, so we need to limit the amount of the deposit as much as possible.  Be sure to ask for specific details about what the deposit monies are for.  Ask for detailed lists of the materials and equipment that will be purchased and how many man-hours will be paid for with the deposit.  This will give you visibility into what you are buying.

Once you understand how the deposit money will be used, negotiate the deposit to be as low as possible.  The deposit should be enough to purchase the materials on the list and for the labor needed for the first few weeks of work.  This will mitigate your exposure while ensuring the Contractor has positive cash-flow.

If you are in a country where commercial contractors require deposits, you can employ this strategy as well.

Milestone payments

If you provided a deposit or any upfront money, then all subsequent payments should be structured as milestone payments.  If you did not give a deposit, then all payments should be made this way.

Milestone payments are payments that are planned according to the progress of the work.  Payments may be made on a monthly (or other periodic basis) or based on completion of specific (clearly defined) portions of work.

Regardless of how your payments are structured, you should know what labor and material is included in each payment and you should verify that all payments claimed are for work that has been completed.

Schedule of Values

If the work you are doing includes multiple subcontracts, or there are multiple phases of work, the very first thing you should require is a schedule of values.

A schedule of values is a list of subcontracts or list of tasks required to complete the work.  How the list is structured is less important than ensuring the list is a complete accounting of all costs.

This list should be prepared by the contractor and approved by you before any payment is made.  As payments are issued, the contractor should update the schedule of values to reflect previous payments made against each task or each contract.  The contractor should maintain a running tally of payments until the very end when the final payment should reflect a full payment of all tasks or contracts needed for the project.

Cash-flow Forecast

Larger projects requiring appropriation of large sums of money should also include a cash-flow forecast.

Cash-flow forecasts are used to show that the contractor has properly set aside capital to perform the work.  Proper planning in this case means the contractor will have enough capital to pay his subcontracts and to buy materials when needed without needing to ask for payment.  This is most important when a contractor has limited access to capital or when the capital outlays of a project will be very high.  It can also be used to ensure that the contractor is properly applying payments made by the Owner.

Ask for a cash-flow forecast anytime you have a project that requires large fluctuations in capital (i.e. one or more milestone payments will be 50% or more higher than all other payments), or if you have any concerns with the contractors ability to manage capital.

Payment Schedule

To ensure that all parties are aligned with respect to payments, it’s best to ask the contractor to provide you with a Payment schedule.

Now it may be confusing, but a payment schedule and a schedule of values are not the same thing.  A payment schedule is the contractor’s projection of how much each milestone payment will be.  A schedule of values is a list of how much each contract (or task) costs.  A payment schedule may also differ from a cash-flow forecast in that the cash-flow forecast is a more detailed account of how much capital the contractor will need.  These items are all related, but they all provide different information.

You should always ask for a Payment Schedule no matter how big or small your project is.  I also recommend adding the payment schedule into the contract as an exhibit.

Application for Payment Process

In order to manage all of these payments, your contract should include an application for payment process.  This process is a predecessor to the invoice process and should include a review of application by your Architect (if you have one).

The application process is a preliminary step that the contractor must go through to demonstrate to the Architect that the work he plans to invoice for has indeed been completed.  This process typically includes (or corresponds with) the Architect’s walk-through of the job site.  During the walk-through the Architect will visually observe the work and will validate that the amount of work claimed to have been completed has indeed been completed.  The Architect then signs and seals the application and forwards it to the Owner as proof that the work has been completed.  The Owner may not issue a payment for any work unless the Architect has certified the payment.

Use this process on every project every time.  Even if you don’t have an Architect, be sure you (or someone who understands the scope of the work) verifies completion of the work before a payment is issued.

Retainage

The practice of retaining a certain portion of the amount due has been around for a long time.  The idea is to withhold a certain percentage of the amount due to a contractor until the end of the job to ensure that the contractor does not leave without completing the work.  Typically the retained amount is a value equal to the contractor’s profit.

The way this works is that each milestone payment is reduced by the retainage amount.  So if you agree to a 10% retainage, then each milestone payment will be 90% of the amount due.  You will then need to keep a running tally of the retained amount which will all be paid to the contractor once the work is completed.

One thing to note is that contractors have developed a practice of trickling down retainage to their sub-contractors.  I wrote an entire article on this topic and discussed why that should not be allowed.

You should use payment retention on every milestone payment for every job.

Lien Waivers

Liens are encumbrances added to your property in order to secure payment of an unpaid debt.  Anyone who works on your property (whether they are directly contracted to you or subcontracted through a GC) can file a lien on your property.

Lien waivers are documents from service providers that certify that they have been paid and that they are waiving their rights to lien your property for a given sum.

There are conditional and unconditional lien waivers.  The only difference between these two is when the payment is received.  Regardless of which kind of lien waiver you get, you should be certain to request a lien waiver with each milestone payment and then also a final one at the end of the job.

Ask for lien waivers for every payment and from every service provider every time.

Close-out and Final Payment

At the end of the project before you make any final payments you need to follow a strict close-out procedure.  This involves walking through the job site (with your Architect) to observe the condition of the work.  Your contractor and your Architect should be developing lists (called punch lists) of any work that is incomplete or requires to be redone.

The contractor should always be required to develop his own punch list ahead of anyone else’s walk-through.  He then should walk through the job site with the Architect carefully reviewing each of the items he has on his list.  The Architect should be reviewing the list and looking for items of his own to add to the list.  The result should be a comprehensive list of all of the miscellaneous small touch-ups required for the contractor to turn-over a perfect and complete space.  Final payment is made ONLY after all punch list items have been completed.

Follow strict close-out procedures on every job every time and be sure never to release the retained amount or final payment until the punch list has been completed.

Closing

As you can see there are a lot of processes and procedures that can be used to manage contractor payments.  You should be observing all or most of these processes every time.  Never make a payment without being perfectly sure what the payment is for.  Leverage the experience and expertise of your Architect during these processes and you will never be second guessing yourself.

What about you?  Do you use these processes during your projects?  Are there any processes that I did not mention?  Tell me your stories.

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