In his article, Earl explains how contractors who can’t qualify for bank or bond credit can utilize a factor that has a relationship with a surety to obtain working capital. Read his full article below:
Factors and Sureties: Peaceful Co-Existence
The United States is experiencing modest growth in public sector construction. However, credit access continues to be difficult for new, small to mid-sized contractors and subs, particularly minority-owned, disadvantaged or service disabled veteran-owned contractors and subs, whose participation in publicly funded projects is often mandated for economic development.
A contractor or sub who does not qualify for bank or bond credit may consider working with a factor that specializes in working with construction contractors that has a relationship with a surety and employs the following Risk Management Tools. Factors and sureties, both extenders of credit, are often polarized when it comes to deal participation, though, and need to “step out of the box”, understand each other’s complimentary characteristics and establish criteria to work together. By doing so, they can create an important opportunity for themselves and provide the working capital and bond credit for both small to medium size general contractors (GC’s) and subcontractors who desire to compete in today’s public works sector.
Risk Management Tools
The proper and thorough evaluation of a contractor’s character, credit and capacity are essential for the success of any of these programs. The character of the principals of the company is evaluated through the review of their personal credit history, reviewing tax returns, checking references and evaluating past performance. Corporate credit is evaluated similarly by, as a minimum, reviewing the past three years and year-to-date financials and tax returns as well as reviewing current accounts payable and accounts receivable aging summaries, running corporate searches to ensure that they are a viable, legal entity, determining who, if anyone, has filed liens on the company and checking references.
A major difference between the surety and the factor in the financial evaluation of contractors is their perspective on the availability of working capital. If the contractor has adequate working capital, which usually amounts to a ratio of at least 10:1 project size to available capital, the surety will usually approve the contractor for bond credit with no or minimal conditions.
If the contractor lacks an adequate amount of working capital, however, the surety may condition their issuing of bond credit on the requirement that the contractor provide collateral in the form of cash or an “Irrevocable letter of credit” (ILOC), require “funds control”, or both. If the contractor gains access a to factor experienced with construction contractors, working in conjunction with the surety, the factor will be able to provide the working capital, in lieu of collateral, and the “funds control”, allowing the contractor the ability to keep cash in the company for other projects.
The factor will, also, employ other risk management tools that will allow them to continuously monitor the financial health of the contractor:
1. Employ a tax service to monitor the contractor’s tax payments with all appropriate tax entities.
2. Require the contractor to employ an outside payroll service that provides a Human Resources (HR) function, to ensure taxes are paid in a timely manner and that the contractor is in compliance with all current employment laws, rules and regulations.
Initial Plan Review
Once underwriting is completed and the contractor is approved for both a factoring facility and a bond capacity, the next step is to evaluate the project to be bonded through an initial plan review. This ensures that the contractor has adequately estimated the project; has the capacity to perform the project for both the estimated costs and in the time required; and that the project owners and/or GC’s have the financial capacity to complete the project. It is essential to review that all parties have the ability to pay for the client contractor’s services through the end of the project. Once this phase has been successfully completed, the project is approved for factoring and bonding and the project is entered into the Funds Control System.
Funds Control Program
Funds Control is the outsourcing of accounts payable by the contractor to a third party to provide a high level of assurance to project owners, contractors, surety and lenders that project proceeds will be used to pay project expenses before they will be used to pay any other expenses. Both the factor and surety mandate the use of this service for similar reasons.
The “funds control” process for both the surety and the factor are quite similar. The third party puts all of the project information into their construction accounting system, including the project cost and income budget, schedule of values, information on all subcontractors and suppliers and the project construction schedule. A separate escrow account for the contractor for each project is established so there is no co-mingling of funds and the third party can make project expense payments in the name of the contractor.
In each case as a new project is set up in the system, the third party, working through the client contractor, will require the owner or GC to acknowledge in writing that they will forward all payments to the third party rather than give the payment directly to the contractor. Concurrently, the contractor agrees in writing that, if they receive payments directly from the owner or GC, they will immediately provide that payment to the third party or be subjected to additional costs or legal fees.
The major difference between the two programs is that, in the case of the surety, the third party waits for payment to be received from the owner or GC to pay job costs. In the case of the factor, once the contractor submits a pay application for periodic payment to the owner or GC and the owner or GC verifies that they have accepted the work performed and will pay the amount of the pay application—the contractor is able to “sell” the pay application or invoice to the factor, who will advance funds to the third party. It is done through a “funds control” escrow account to disburse funds to pay job costs on the project, including payroll and project specific, budgeted overhead.
Periodic Project Inspections
Throughout the course of the project, the factor will schedule a series of Periodic Project Inspections to ensure that the work is being performed to the satisfaction of the GC and/or owner in accordance with the project plans and specifications. The site visit will be used to verify the use of budgeted material, ensure compliance with safety standards and provide all parties with a periodic report of the status of the project. The number of inspections will vary based on size, complexity and length of a project. This information is transmitted to both the factor and the surety to ensure that all risks related to the project are being managed properly.
Sharing of Collateral
The final piece of this puzzle is whether the two extenders of credit are able to share their interest in the most important collateral in the transaction: Project Receivables. In order to “purchase” a receivable to pay job costs on a project, the factor must have a first position lien on that receivable, a position provided by filing a Uniform Commercial Code agreement-1 (UCC-1). The surety that has issued the bonds on a project has an implied first position on the receivable by legal precedence, whether they have filed a UCC-1 or not. Since the factor is paying project expenses with the advance generated by the purchase of the invoice and reporting all project expense payments to the surety on a regular basis, there should not be a conflict! By completing the “initial plan review” and determining that there are adequate funds budgeted for the project and through constant monitoring of the financial management of the project through the “funds control” program, both entities are constantly aware of the financial status of the project and should be comfortable with the process.
Can the factors and surety become a team? YES indeed they can!
Earl Harper, SVP, RMP Capital Corp. USA