Surety companies hound contractors to build up capital in their company and this is one of the key factors that determine how much surety capacity they will extend. I often think from a contractor’s perspective that it must be hard to understand why sureties focus on a company’s capital so much. If the business is running just fine, what’s the problem, right? In some ways this may be true, but sureties do see a lot of contractor financial statements, and they have a front row seat to what happens when things go wrong. In this article, we’re going to look at one such example where a single project cost a contractor $3 million and almost put a 20-year-old-company out of business.
The details have been altered slightly to respect the privacy of those involved, but the essence remains the same.
Behind the Scenes
Our contractor had been in business for over 20 years. They were very successful and had completed projects as large as $14 million.
In 2010, they were presented with an opportunity to work on a project with an owner they had prior experience with for an $11 million job. They bid it and were ultimately awarded the work. It was the same type of work they had done before, and they bid it with a good profit margin of $1.6 million.
The project was supposed to take 2 years to complete. The job started off okay, but it soon became apparent, there were problems with the plans and unforeseen conditions. These caused delays, and by 2014, four years later, the project was only about halfway complete. The contract had grown to $20 million, and the contractor was estimating to lose $4 million. There were tons of change orders that the owner was disputing. The contractor considered walking off the job many times, but he was advised by legal counsel that would only make things worse.
The company was well capitalized when they started the project with $2 million in equity in the company, which was more than sufficient to manage the $15 million backlog they had from the surety’s perspective. However, by 2014 almost all of the company’s capital was tied up in disputed receivables and change orders with the owner. On paper, those claims may have had value. In reality, they couldn’t be used to make payroll on Friday. The contractor borrowed every dollar on their $1.5 million bank line of credit, and they had no way to get any additional cash.
Week by week they muddled through the job and ultimately finished in 2015 – more than three years later than expected. The contractor made up a little ground financially on the project and ended up losing $3 million, but it essentially wiped out their capital. It took them 6 more years of fighting and almost $1 million of legal expenses, and they finally prevailed in their lawsuit. What did “prevailing” look like, they won just over $3 million, which resulted in them losing about $1 million on the project after legal expenses.
Lessons Learned
One thing I hope contractors learn from this story is that when things go bad, they can go really bad. We work with a lot of incredible contractors who are generally right about the disputes they are forced to fight, but being right doesn’t pay the bills, and those fights can take years to resolve – six years in this example. In order to get to the finish line and “win”, contractors need to have the capital to get there.
Our contractor survived, because they had a strong capital base, a large line of credit that was fully available, and the mental strength to persevere.
So, next time your surety wants to talk about the capital in your company, remember that it is not just for their benefit, it’s for yours.
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