What Causes Contractors to Go Broke?

Bankers who specialize in contractor financing, and the surety companies who must make good on contracts when the builder defaults, agree that the biggest single reason for contractor failures today is that they take on too much work. One of the top bankers in the field summed up a sentiment shared by the surety firms when he said, “The cases of complete failure that I have seen over the years are usually those where a contractor has spread resources so thinly over a number of jobs, or has concentrated them so greatly in one or two jobs, that he did not have the safety margin required to absorb a loss.”

Of the two extremes cited – the contractor who has too many jobs and the person who has everything sunk in one or two big jobs – it is the first problem that seems to be the most serious. When the volume of work poured forth in the post-war period, two significant things happened. More firms entered the field, and the existing firms built up their organizations to handle a larger volume of work. When competition became tight, these firms bid lower and lower to get contracts.

As a result, profit margins shrank and instead of trying for fewer jobs and higher profits per job, many contractors went after a bigger volume of contracts and held their profits to a minimum. When they bumped into unforeseen problems, they could not weather the storm.

Not Enough Capital
When a contractor goes to the bank for a loan or to the surety for a bond, one of the first, and one of the most important things checked is the amount of uncompleted work the contractor has on hand. Some bankers use a rule of thumb that a contractor should not take on any new work whenever uncompleted work adds up to more than ten times working capital. This rule, like many others, is only a guide. There are many times when a banker will ignore it, particularly if the contractor can show that he doesn’t have all of his personnel and equipment tied up on present contracts, or when some of the contracts are close to completion.

Overextended contractors sometimes get bank loans or surety bonds they do not actually deserve. This contributes to the failure rate and even more to the heavy losses absorbed by the sureties. They get backing because banks and surety companies want contractors to grow. If a firm has a good record and looks outstanding, bankers and sureties hesitate to hold the company down. When they’re right, and they often are, the small contractor finds it easy to become big. When they’re wrong, which also happens, the contractor takes on too much work, falters and begins to sink. Then the surety companies launch an expensive rescue.

An example of this involved a Midwest construction company which had grown slowly over a period of 30 years. When the founder died, his sons, both of whom had been in business with him for several years, took over. Less cautious than their father, they went out to aggressively build up the business. Within a short time, they had contracts in a seven-state area, and their working capital, equipment and trained personnel spread thinner and thinner. Some of the contracts turned out to be far less profitable than expected. When trouble developed on two of their jobs almost simultaneously, they were on the verge of bankruptcy.

In this case, because the firm was basically sound, the surety company kept them in business. With a more conservative approach, the sons discovered they still had an opportunity to grow and they turned the company into an outstanding business success in later years. But they had learned a lesson the hard way that many contractors today might heed.

Lack of Experience
Tied in closely with the volume of work a contractor has under way is experience, or lack of it, when trying to switch from one type of construction that is beginning to lag to another type which is booming. Surety companies rate lack of experience well up on the list of reasons for contractor failure. They describe variations on the now classic “upside down sewer” story from the 1930s.

Sometime around 1932, a builder who had been highly successful in sewer construction watched his contract volume dwindle away rapidly and decided to try some other type of construction. He submitted a bid on levee work on the Mississippi and went to the surety company for a bond. When the surety questioned his lack of experience in levee work, he commented with great sincerity that in his opinion, a “levee is a sewer upside down.” Instead of removing earth, as he did in sewerage work, he would simply have to “pile it up” for levee construction, he explained. Because of his past record, the surety company gave him a bond, even though it had some obvious misgivings. The builder quickly learned a new vocabulary – terms such as “burden” and “berm” – that translated into trouble. The surety brought in an expert levee firm after the contractor defaulted and the original contractor achieved a comparatively rare distinction – he went broke on one job.

Poor Record Keeping
One ghost that haunts bankers and surety firms at all times is a contractor’s poor financial records. This is what is usually meant when a contractor is condemned for “poor management”. Experts cite case after case of contractors whose accounting methods are so inadequate that they don’t know themselves when they’re in trouble. Beyond a look at the highly unreliable barometer of the bank balance, many a contractor has no idea whether or not he is making money. Payments for one job are comingled with another, liabilities are haphazardly calculated and profits are only a guess.

A somewhat embittered surety expert who spent long hours in detective work trying to find a profit in a contractor’s operations said, “Too many builders use the proceeds of the current job to pay old bills. Their constant hope is that the work under way will somehow bail them out. Two losses back to back and another contractor is out of business.”

And Poor Planning
Sureties, in theory, do not expect losses when they write a bond. As a practical matter, however, they know they will have to take it on the chin from time to time, and poor planning by the contractor is one of the reasons. Some examples of poor planning: failure to get a detailed survey of a job site (which led one big earthmoving contractor to heavy loss when he ran into hard rock that should have been discovered before the job was bid); failure to plan materials deliveries far enough in advance, especially when certain items are short; and failure to organize the project in such a way that subcontractors get on and off the job in order to do the work on schedule.

These are management failures that can be avoided, and there are others too that carry a lesson for contractors. Just as some builders seem to avoid accountants, others appear shy about seeking legal advice. One contractor ran into serious trouble because he turned the building over to the owner and then cancelled the fire insurance which had protected him all through the construction period because he believed he had been relieved of his obligation. However, it turned out that the building had not been formally accepted by the owner, and before it could be, a fire destroyed virtually the entire building. When the case went to court, the contractor and the surety were held liable. The contractor went bankrupt; the surety suffered a heavy loss. But a routine check with his attorney, who probably would have warned him about his continuing liability, would have persuaded him to keep the fire insurance a short time longer – and he might be in business today.