Is Your Bond Company Slowing Your Growth
Is Your Surety Bond Company Slowing Your Growth?
Bonding facilities are generally subject to both a single contract limit and an aggregate contract limit. These limits are determined by a multitude of factors such as the financial position of the company, the contractor’s past experiences and the profitability and progress of the contractor’s current backlog. While most consider these construction bond limits to be more of guidelines than firm limits, they do represent the amount of exposure the bond company feels comfortable taking on for any specific contractor.
This year however, the rising costs of construction materials combined with prolonged contracts due to material and Covid delays have presented a unique challenge for both contractors and sureties. What happens when the dollar value of a construction project simply increases due to material costs rather than an expansion in scope?
XYZ Construction Company
Let’s use an example of XYZ Construction Company. XYZ has a $5M single contract limit and a $10M total aggregate work program supported by their bonding company. Last year XYZ successfully completed a bonded $5M new office building for a private owner. The owner has returned to XYZ and asked them to build the exact same building across the street. XYZ calls all of its sub trades with the good news and asks for updated pricing. Despite this project being identical to last year’s build, the new pricing comes in higher at $6.8M this time, with all the trades especially the concrete and finishing trades blaming higher material costs for the price increases. XYZ shares this information with the owner and the owner agrees to the higher price but reaffirms to XYZ that both a performance bond and a labour and material payment bond will need to be provided for this contract.
Next up, XYZ shares the good news of the contract award with their bonding company. Unfortunately, the bond company has immediate concerns with the dollar value of the contract citing the single limit of $5M. XYZ also has also recently secured $5M in other new bonded contracts that are just starting up so adding this contract would also push XYZ over aggregate bonding limit of $10M. After a review of the contract, the bond company declines to issue the bond. Their position is that XYZ has never managed a job over $5M and has concerns about both their experience with larger contracts and their ability to cash flow the project alongside their current bonded backlog. As XYZ was unable to furnish the bonds as required, the owner pulls the contract and XYZ is left feeling very frustrated. What did their bond company not understand? This was essentially the exact same job they had previously completed and the rising costs of materials is something outside of their control. XYZ also has pay when paid clauses and plus this project is located in Ontario and falls under the new Prompt Payment legislation so cash flow will not be an issue.
This is just one example of a scenario where a contractor has lost out on a great opportunity due to a lack of sufficient bonding capacity. When these situations occur, it is important to understand what options contractors have at their disposal to expand their bonding capacity.
Character, Capital & Capacity + Relationships & Trust
If you recall from previous Surety Corner articles there are the 3 C’s to surety – character, capital and capacity. We also believe that R and T – relationships and trust – are fundamental to any successful long-term surety/contractor partnership as well. In the same token, there are times when a contractor/surety partnership has reached its end and a new perspective is required.
Over the summer, Surety Corner will be exploring the various option contractors have at their disposal to increase their bonding capacity – both from a single contract perspective and an aggregate bond program consideration. The first part of this series will be focused on Capital.
Part 1: Using Capital to Increase Your Bonding Capacity
Construction bond companies focus heavily on the financial strength of a contractor at any given point in time and one of the key metrics they rely upon is working capital. As noted in previous articles, working capital is a figure determined by adding a contractor’s cash position and receivables less any payables (trade payable, current debt payments, wages, etc.). Using the example above and standard surety leveraging for general contractors, contractor XYZ would likely require $500k in working capital to qualify for a $10M aggregate limit bonding program. Upon review of XYZ’s most recent year-end financial statement, the surety has determined that XYZ had a working capital position of exactly $500k, which meets its covenant for the $10M aggregate. However, XYZ are looking to take on a larger job and to fit this project into their backlog they need to increase the aggregate limit to $12M.
So, based on the above scenario what options does Contractor XYZ have available to boost working capital and ensure they have the adequate limits available?
The most common, easiest and quickest approach to increase working capital is a solution known as a capital injection. In the scenario described above and using 20 times leverage of working capital, contractor XYZ requires a minimum of $600,000 in working capital to achieve a $12M aggregate. With a current working capital position of $500,000, XYZ will need to add another $100,000 in working capital. With a capital injection, the owners of the construction company would inject $100,000 in cash into the business, usually via a shareholder loan and subsequently subordinate that amount to the bonding company. The subordination is a formal agreement that allows the loan to be treated as equity and working capital with the contractor agreeing to leave those funds in the company to support the business. These funds can be utilized by the XYZ to pay for business expenses (trade payables, wages, etc.).
What if the owners of XYZ don’t have the cash available to inject into the business?
If the owners of XYZ do not have the cash or prefer not to loan the company this money, then we will need to look at ways of organically increasing working capital. XYZ has borrowed $100,000 from its operating line of credit, which is negatively impacting its working capital position. In order to boost working capital, contractor XYZ chooses to approach their operating lender and asks them to considering “terming out” this debt. This means that rather than the debt being considered current debt and repayable on demand, the bank agrees to structure this debt as a term loan paid back over multiple years. In this case, the bank agrees to let XYZ repay the $100,000 debt over 5 years so the current portion owing is only $20k. This results in a net increase in working capital of $80,000. XYZ now has $580,000 in working capital so now a much smaller capital injection of $20,000 bring them to the $600,000 required.
Turning over receivables and updating your bond company
Receivables are another area that could be dragging down your working capital. Many surety companies will look at receivables over 90 days and discount those from working capital as they consider it doubtful that these amounts will be collected. Ensuring that you are following up on aged receivables and identifying to the bonding company which items are holdback (holdback is included in current assets and thereby working capital) will ensure you are getting the most credit you deserve.
XYZ has $500,000 in receivables but $100,000 of these are over 90 days so the bond company has discounted this amount from the working capital position of XYZ. Once investigated it turns out that $50,000 of this collected last week and the other $50,000 is holdback payable in 3 weeks. With this good news, the bond company credits the $100,000 back to the working capital position of XYZ.
Part 2: Using capacity to increase your bonding limits
Ultimately, most surety companies are financial entities are heart. The majority of people working at surety companies are accountants or finance experts by trade and most do not have a formal education in construction. As a result, a contractor and their broker’s ability to clearly explain the contractor’s operations is critical in boosting limits and securing that stretch job. Doing this effectively can sometimes allow a contractor to increase the bonding capacity without increasing capital right away.
A good example of this is contract structure. Many contractors will sign lump-sum construction contracts such as the CCDC 2. However, many also utilize different contract structures like construction management such as the CCDC 5B. The difference in risk between a lump sum contract and a construction management contract where the owner signs the contracts directly with the trades is substantially different. In the construction management (not at risk) scenario the risk of a sub-trade default or dispute is moved to the owner. Explaining this risk clearly and how much of a contractor’s backlog is not at-risk can allow for additional leveraging.
What is Capacity?
Capacity is essentially a contractor’s ability to take on and successfully manage their workload. Many expect that this refers simply to the ability to successfully execute contracts in the field.
While this is of course a key aspect for any contractor, from a bonding underwriting standpoint, a contractor’s ability to properly provide accurate and timely financial reporting as well as accurate job progress and costing reports is also an integral part of their capacity consideration.
A contractor that can provide good quality financials on a timely basis will help convey that they are on top of their costs and monitoring their jobs closely. Surety company’s put a lot of emphasis on reporting and it gives them comfort that any potential issues on a job can be detected early and corrected before it becomes a real problem.
Quality and Timely Reporting
When we talk about quality financial reporting, we are referring to both the year-end financial statements prepared by your CPA as well as your internal, interim reports. The bond company will be looking for different things when determining if they are of good quality and ultimately reliable.
When it comes to year end statements, the standard for bonding is a CPA review engagement. A CPA review engagement is preferred over a notice to reader because of the level of scrutiny required by the CPA to verify that the numbers are accurate.
Compared to notice to reader statements, A CPA review engagement requires the accounting firm to perform various analytical procedures, as well as undertake discussions with the client to ensure that the financial statements are accurate. Should the CPA have that level of comfort, a review engagement report can be issued.
By contrast, a CPA notice to reader provides no such assurances from the CPA that the statements are free from material misstatements. They are effectively taking the numbers provided by the contractor and putting them into a financial statement format.
It is for this reason that a bond company will find it easier to rely on the accuracy of a review engagement and in turn feel more comfortable extending support for larger jobs and higher bonding limits. In fact, when contractors reach certain annual revenues, or are looking to get performance bonds for construction projects over $1M, a review engagement is often a firm requirement.
Internal Financial Reporting – Quarterly or Semi-Annually
The focus on quality Internal reporting is a different issue in that the statements aren’t typically done by a CPA, rather it can be done internally using a software like Quickbooks or with the help of a bookkeeper. It is very important that the internal statements make sense and all of the entries and adjustments are made so that there are no errors on the statements. For example last year’s retained earnings plus net profits should equal this year’s retained earnings.
If they don’t, the bond company will lose confidence in the other numbers and this can affect your ability to stretch to higher limits if need be. The internal financial statements should include a balance sheet, income statement, aged payables and receivables listings and a work in progress statement regardless of whether there are over/under billings. The more details that can be provided the more organized and fiscally responsible your company will appear only leading to underwriter confidence and ultimately higher bond limits.
Timely reporting is also imperative. Timely reporting gives the impression that you are up to date with your accounting and not only know the operational side of the business, but also the financial side.
This is especially critical for smaller or growing contractors, as this is a common growing pain for these types of contractors and a reason for concern amongst surety bond underwriters. The theory goes that if you don’t know if you’re profitable, how can you expect a bond company to support your business? It’s simply not enough to tell an underwriter how great things are going, you have to show them.
Circling back to our example with XYZ Contracting and their need to increase their aggregate bonding limit to $12M. XYZ Contracting provided their bond company with their December 31st, 2020 Review Engagement financial statements which showed $500,000 in working capital.
As we are now more than 6 months past their year-end date, XYZ has recently provided their bond company with an internal balance sheet and income statement from their internal accountant as at June 30th, 2020. The 6 months results are excellent with $300k in profits on $1.5M in sales. These profits have increased XYZ’s working capital position from $500k to $800k, which exceeds the bond company’s requirement of $600,000 in working capital for the increased aggregate bonding program.
However, the bond company does have some concerns about the high level of profitability relative to sales and is questioning whether XYZ is over stating its interim profitability. Could XYZ be over billed on some of its contracts?
Work In Progress Report
From experience bond companies know that the internal financial reports are not always accurate and so the sureties often request a corresponding Work In Progress or Work on Hand report to allow for a deeper analysis of the financial report.
This report is produced at the same date as your financial statements, and requires that for each job the contractor input estimated costs remaining, costs incurred to date, total revised revenues to date and total billings to date. Using these numbers, the underwriter will be able to get a completion percentage for each job based on costs which they can then use to calculate the earned revenue. By comparing earned revenue to the actual amount billed, the underwriter can determine if the contractor is under or over billed and check to see if this is reflected on the financial statement.
What is an ‘Under Billing’?
When using the percentage of completion method of revenue recognition, there will be times where a contractor is under-billed on some of their projects. This means they’ve incurred expenses, but not yet billed the project owner. There can be a multitude of reasons for this including disputes regarding billings but for this example we will assume it is a timing issue and the billings are collectible. If so, and the contractor is not recording a provision for work in progress then they are understating their interim profitability.
Under Billings Example:
Contract Value: $1,000,000
Costs Incurred to Date: $350,000
Costs Remaining: $350,000
Expected Gross Profit: $300,000
% of Completion: Costs Incurred to Date / Total Expected Costs = $350,000 / $700,000 = 50%
Profit Earned to Date: Expected Gross Profit * % of Completion: $300,000 * 50% = $150,000
Billings to Date: $400,000
In this scenario the contractor has incurred costs to date of $350,000 and earned $150,000 in profit. As such, the total revenue to date on the project should be $500,000. However, the contractor has only billed $400,000. If an under-billing provision isn’t taken then the contractor is understating their profitability by $100,000.
What is an ‘Over Billing’?
The opposite of being under billed is being over billed. This commonly means that the contractor has front loaded the billings on a project. If a provision for over-billings isn’t made on the financial statements then they could be overstating their profit.
Over Billings Example:
Using the same figures in the above example, we know that the contractor has incurred costs to date of $350,000 and earned $150,000 in profit. As such, the total revenue to date on the project should be $500,000. However, the contractor has already billed the client for $700,000. If the contractor just records the revenue of $700,000 without an over-billing provision of $200,000 then they are overstating their profit.
Looking back at the XYZ Contracting example, the surety company wants to confirm that the six months interim profits $300,000 on $1.5M in sales are in fact accurate before agreeing to increase bonding limits off the additional profits. After a thorough review of the Work In Progress report prepared by XYZ Contracting, the surety does in fact determine that XYZ is over-billed by $150,000. This results in the surety adjusting the interim working capital position of XYZ from $800,000 to $650,000. However, despite the adjustment, the adjusted working capital position of $650,000 is deemed sufficient to increase XYZ’s bonding limit from $10M to $12M and the surety now agrees to issue the performance and labour & material payment bonds for the new $6.8M contract.
The Importance of Interim Reporting
Surety underwriters sometimes have little else to rely on except for financials. Although it can be a real challenge staying up to date with reporting while running a busy construction company, good quality interim financial statements produced on time can make a real impact on your relationship with the bond company. If your company is doing well, take the time to set things up right so that reporting becomes a simpler part of running your business.
Character, Relationships & Trust
In the bonding world character, relationships and trust are still a critical part to building bonding capacity, securing that stretch job and also ensuring you can maintain support even in tough times. For bond companies these are often the toughest things to evaluate but if you can put yourself, your company and your team in a position that the bond company has a high degree of trust and comfort in you then it will set your business up for success.
Annual Bond Company Meetings
If you are a regular used of bonds, any good bond broker will ensure that you have a chance to sit down with the bond company. Not only is this an opportunity for them to ask questions about you and your business but it should be looked at as an opportunity for you to understand more about the bond company and what they are focused on. In addition, many of these underwriters are having regular conversations with dozens of bond brokers and contractors and so will have a good pulse on many of the market dynamics and hot button issues that contractors are facing.
A bond broker should be setting an agenda with the bond company ahead of time and also be sitting down with you prior to the meeting to understand the agenda. They should also be asking you for feedback on the agenda so topics can be added for the bonding company to present on. These meetings should not feel like an inquisition and for maximum benefit should be structured as an open back and forth conversation where both parties are learning about the other.
Action items from the meeting should be compiled afterwards, shared with each party and the bond broker should ensure that any follows ups are acted on promptly to ensure maximum value for each party.
Unfortunately, many contractors view these meetings as a necessary evil, attempt to withhold as much information as possible and treat it like a zero-sum game. If your bond broker has placed you with a reputable company that understands the surety business you are doing yourself a disservice if that is your strategy. Ultimately, the bond company doesn’t succeed if you don’t succeed and so their goal is to help you and your business to secure profitable opportunities, advise you on common pitfalls and help you de-risk your business. At the end of the day the bonding relationship should be viewed as a partnership.
Another common pitfall contractors run into is being slow to share challenges they are having in the business. In any good partnership, both sides want to avoid surprises. Bonding is not different. A contractor doesn’t want to be surprised by an out of the blue decline of a bond and the bonding company doesn’t want to be surprised by a significant loss.
At the end of the day, bonding companies go through challenges with their contractors regularly and understand that there is risk in the business and sometimes contractors will experience a tough job. Similar to the transparency point, bond companies and bond brokers have a wealth of experience in helping contractors navigate tough times.
If you are avoiding sharing information about a challenging business issue you could be depriving yourself of another answer or solution you possibly had not thought of.
Our advice to our contractors is to share challenges readily with your bond broker and bond company but at the same time ensure you have a reasonable road map on how you are going to emerge from the challenge. Nothing will forge a bonding relationship stronger than parties sticking through tough times together, openly communicating and delivering on a plan to manage complex business issues.
Over this past 5 part series we hope you have been able to get a better glimpse into the items that might be holding you back in your relationship with your bond company. Remember, as a business owner, your goal should be to surround yourself with partners, advisors and relationships that will help you grow and manage risk in your business. If you are not building a relationship built on trust you are doing yourself a disservice.