It seems that at least once a year, I encounter someone with the impression that construction contracts would benefit from extended payment terms.
I fully appreciate the argument about cash-flow and the time value of money, but at a time when interest rates are so low, the risks may not match the rewards.
I’ve seen Corporate policies that mandate everything from 60 day to 90 day and even 180 day payment terms. Recently I even came across a scheme that uses third party payment aggregators to get payment terms to be as long as 365 days.
I’ve addressed this topic in the past, but it seems that a refresher is in order as I am once again seeing this topic rear it’s ugly head.
Who remembers the liquidation of Carillion?
When the second largest construction company in the UK went bankrupt, it left more than £2B in debt, causing a financial ripple that was felt by over 30,000 subcontractors and suppliers. The failure of Carillion was the result of several layers of mismanagement, but a major factor in Carillion’s failure was it’s abuse of extended payment terms.
Abuse of Subcontractors
In a 2018 article, Forbes reveals how Carillion mis-used the “Supply Chain Finance Scheme” to extend longer payment terms onto it’s small business subcontractors. Under this scheme Carillion forced it’s subcontractors to take small business loans rather than paying them what they were owed. When Carillion went bankrupt, subcontractors were left behind unpaid with hefty loans to bear.
The abuse of Carillion is an example of how prioritizing cashflow to enhance profitability impacts the supply chain. However, even under well-meaning circumstances, the lag between completion of the work and payment for that work can be quite long.
Typical Payment Process
Most design-bid-build contracts include a payment application process that occurs ahead of invoicing. The process requires a site visit by the Architect to verify completion of work. If this process is performed properly, it protects the Owner from paying for incomplete or improperly performed work, but it also adds time to the payment cycle.
So let’s create a fictitious example (making several assumptions along the way) and run through the process of paying a General Contractor (GC) when a payment application process is included in the contract.
Let’s say your GC hired a Carpenter to do framing work for $100,000 and let’s assume the Carpenter begins performing work on September 1. The work is completed September 15. The Carpenter then submits an invoice to the GC.
Let’s assume the Carpenter is really efficient and submits the invoice the same day the work is completed. The GC receives the invoice on September 15.
Let’s also assume the GC inspected the work the same day and the GC is happy that it was performed correctly and no correction is needed. Now the GC owes the Carpenter $100,000 for work he and his team completed on September 15.
The Carpenter’s Payment Terms
Let’s assume that the GC’s contract with the Carpenter states that payment is due immediately upon completion of the work, but the GC slipped in a pay when paid clause which now means the Carpenter has to wait for the GC to be paid before the Carpenter can be paid.
In keeping with the application for payment process, the GC prepares a payment application and presents it to the Architect for review and approval.
The application for payment must be certified before the GC can present an invoice to the Owner.
Typically this process specifies that the Architect must review the amount of work the GC claims to have completed and the Architect must certify that the application is accurate. This requires a physical walk-through of the job-site by the Architect.
Architect’s Site Visit
The Architect is not on site every day. Typically Architects will visit a jobsite once or twice a month. In some cases, the Architect may visit once a week (assuming a short fast moving job).
But let’s say that the Architect’s visit happens the following week (7 days after) the Carpenter completed his work and let’s also assume the GC is very efficient and he is able to include the Carpenter’s scope in the Application for Payment.
The Architect completes his walk-through and agrees with the amount the GC is claiming to have completed. The Architect takes the Application for Payment back to the office where the application is signed and sealed certifying that the work was completed.
Certified Application for Payment
So if the Architect certifies the payment the same day of the site visit, the payment application which includes the the sum owed to the Carpenter will be certified on September 22nd. This is now one week past the completion of the work.
The signed and sealed payment application has to then get routed to the Owner. Many states still use a crimped seal which requires a physical piece of paper with the Architect’s perforated seal, but let’s assume this is a state where a wet (ink) seal is allowed and that the Owner has agreed to accept a scanned pdf of the certified document.
If all of those assumptions hold then the Owner could have a certified application for payment by September 23rd (8 days after the work was completed).
The reality is that many of the assumptions I’ve made in this example won’t hold. In practice, the carpenter’s work might not get certified for payment until 2 to 4 weeks after the work is completed.
The GC may now present an invoice to the Owner. I have seen some GC’s prepare the invoice together with the application for payment assuming that the Architect will agree and certify the full amount, but should there be any disagreements and should the Architect only certify a portion of the sum, the GC would have to revise the invoice in order for the sum of the invoice and the sum of the certified amount to match.
As you can see there are several risks that can easily add another week or more to the payment process.
Not to mention that the payment made by the Owner to the GC has to clear the GC’s bank account before the GC can make a payment to the Carpenter.
So when Owner’s insist on 90 day payment terms they are really creating a situation where subcontractors of the GC are waiting more than 100 days to be paid.
What’s the value of money
So why do companies insist on 90 day payment terms?
Investopia has a great article called “Time Value of Money” where they explain how to calculate the future value of money.
Their article states that the future value of money can be greater than the present value of money. Therefore, when a company holds on to capital for a longer period of time, their net liquidity is increased. Of course this assumes that the company is actively investing it’s capital and earning interest on that capital.
The following formula allows us to calculate the future value of money:
FV = PV x [ 1 + (i / n) ]^ (n x t)
- FV = Future value of money
- PV = Present value of money
- i = interest rate
- n = number of compounding periods per year
- t = number of years
So if we apply this formula to our example and we assume the number of compounding periods to be 1 (for one year) and that the interest rate earned is 8% per year (the rate of increase of the stock market
FV= 100,000 x (1+(8%/1)^(1×1)
This means that the future value of $100,000 will be $108,000 in one year, so if we hold on to the capital for 3 months that 100,000 earns $2,666.67 in interest.
On paper this sounds great and looks like free money in the Company’s pocket, but these practices elevate the Owner’s risk in several ways.
We’ve addressed mechanic’s liens in the past. You can learn what these are and how they work here.
Anytime a trade worker (or anyone performing services on Real Estate) is owed money and there is a default (or the perception of default) on payment, service providers can file a lien on a property.
The lien encumbers the property and prevents the Owner from performing tasks such as financing, selling, trading, or using a property as collateral. If a lien is placed on Real Estate where you are leasing or renting space, you could be in breach of your lease agreement which may allow a landlord to terminate your lease for cause.
Of course you can mitigate this risk with lien waivers and indemnity language in your GC’s contract, but none of those mitigation actually prevent anyone from filing a lien.
Even with these provisions a lien can be filed, your property will be encumbered, and you will be burdened with complex legal proceedings in order to have the lien removed.
When Carillion went bankrupt, it left an estimated 900Million in unpaid debt. Estimates suggest 50M was owed to subcontractors. This meant that many of the trades that properly performed and completed work went unpaid.
This had a rippling affect throughout the industry. Many subcontractors like Sammon Contracting Group were unable to remain in business, leaving several school projects unfinished and over 200 workers unemployed.
When trade workers and suppliers learned that they would not be paid for work they completed and supplies they provided, they converged on the site and started to repossess materials. Furniture suppliers came in and took back desks and millwrights that installed railings and handrails came back to cut the railings out and take them back.
It was a devastating scene and a huge setback for the Owner.
Risks versus Reward
For Carillion, the act of extending payment terms was a duplicitous act meant to hide mismanagement at the highest order.
Most corporations with policies requiring extended payment terms aren’t being dishonest, they are simply attempting to realize the greatest value for their capital. However, when these policies are considered without the context of risk in mind, the exposure taken on can be far more impactful than any financial gains.
A thorough analysis must weigh the rewards and the risks of extended payment terms.
I’m certain this will not be the last time we discuss extended payment terms. The appeal of earning interest on capital is simply too great, but if you are reading this article and are in a position to influence payment terms, please consider the future value of capital in the context of all risks. Extending payment terms is not without consequence and we must be informed on these risks in order to make a sound decision.
Does your organization have extended payment terms? How long are your payment terms? What considerations other than the future value of capital did you consider? Tell me your stories.
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