In an ideal world, all construction projects run problem-free with little to no roadblocks during the entire process. In practice, however, issues and complications often come up in every project, and they can cause major disagreements among project stakeholders.
Substandard quality of work and late payments are two of the most common results of poor project planning, among other project issues. One way to prevent these problems from happening to detect early warning signs of any potential roadblock and to nip them before they grow bigger.
Every construction business must know how to identify these warning signs, especially when dealing with clients in unstable financial situations.
Vetting construction clients
The construction industry follows a hierarchical payment structure. Payments are distributed through a top-down chain, so one client’s failure to honor their payment obligations can lead to late and missed payments for all other construction participants.
This is why it is very important to vet potential clients before signing them on for projects. Every company has its own policies for assessing client risks. Some companies might even accept every client who shows interest, but the best practice is to screen your clients so you can at least understand the possible risks that you may deal with once you enter a contract with them.
Below are other reasons why you should vet your clients before working with them:
- To see if you and the client are a good fitVetting potential construction clients are not done solely to find out if they are dealing with financial troubles. You also do it so you can understand if you and the client are a good fit. You want to know not only if they will be able to afford to pay you for your services, but also if you will be able to deliver the services that they need.
One big mistake that some construction companies make is accepting projects that they do not have the resources to complete. Over-promising often leads to bigger issues such as failure to fulfill project deliverables, which could lead the clients to withhold payments.
- To test how reliable they areOne technique that some construction businesses use to assess potential clients is to first get them to work on smaller projects. A subcontractor, for example, can hire a material supplier to supply a small order of goods before putting on a bigger order. This is a screening method that gives you better insight into the work processes of a potential client.
On the flip side, you can also offer a project owner to sign on a trial phase during which you work on a smaller part of a project. This will allow you to have a sense of how they treat construction participants. You want to understand how frequently they communicate with you, how they honor their payment responsibilities, and how reliable they are as clients.
- Avoid dealing with historically delinquent clientsPart of vetting potential construction clients is understanding their track record. If you do a background check, for example, it will help you understand if they had been delinquent to other construction parties by failing to pay them on time, if at all.
Background and reference checks will also allow you to know if those previous delinquencies are a one-time occurrence or if they are indicative of deeper financial troubles. Unless you are prepared to take on high-risk clients, you do not want to work with clients who have historically demonstrated how unreliable they can be.
How to screen construction clients
Verify if they meet licensing requirements
Failure to obtain proper permits and meet local licensing requirements is a warning sign that must be flagged. Troubles may arise if your client does not secure proper permits and licenses. Also, it shows that a client or potential client can be dishonest and may be more lenient when it comes to business malpractices.
Ask for financial statements
Before signing a contract with a new client, you must first understand their financial situation and get a sense if they are able to afford the project and your services. Do not hesitate to ask for their financial statements, and make sure to review them and pay attention to the details. Understand where their funding is coming from. If a project has a construction lender, for example, always ask for information about the lender.
Conduct reference checks
You must not skip doing background and reference checks, especially if you will be working with a client for the first time. You can do a quick background check by doing a basic Google search, but you also want to dig deeper and interview the parties that a potential client has already worked with. This will allow you to get feedback and flag possible risks.
How to assess construction clients for potential financial troubles
Understand where they get their funding from
There are many ways to get funding for a construction project. Property owners and contractors can take bank loans, and there are also other short-term financing methods such as invoice factoring that construction parties can use.
The choice of funding source does not necessarily give a fool-proof sign if a client is in an unstable financial situation or not, but it gives you a basic understanding of how you are going to get paid.
Take note of how frequently they haggle
Asking for discounts is not unheard of in construction. In fact, every potential client might even ask for discounts or incentives so they can save money, which is understandable. Excessive haggling, on the other hand, is a red flag that you must take note of. If a client asks to lower the price every step of the way, they may be dealing with financial hardships that could spell bigger troubles if not mitigated.
Verify the quality of their work
Clients who are in a financial bind do not perform a good job often. They focus too much on resuscitating the cash flow that they fail to meet the quality of work expected from them. This is why you should do reference checks prior to committing to a client. This will help you gather feedback on how well a potential client performs their job.
The problem with construction late payments
Late payments are a huge problem in construction, and there are many reasons why they remain to be an issue. Here are some of them:
- Gaps in communication linesMiscommunication often leads to late or missed payments. If parties are not clear on payment terms and schedules, they will not see eye-to-eye when payments must be expected.
Lack of communication also becomes a problem during construction when the scope of work changes due to unexpected site issues. If change orders are not properly tracked and if project accountabilities are not properly allocated, disputes will come up, and payments will more likely arrive late.
- Issues with cash flow managementClients are sometimes unable to pay on time because they themselves are waiting for payment from another higher-tier party. One missed payment can therefore snowball to bigger payment disputes among parties in the lower end of the contractor chain. The best way to avoid this problem is to manage your cash flow better and to make sure that contingency payment plans are in place.
- Mismanagement of invoicesLate payments are not always the fault of your clients. They can also happen if you issue your invoices late, so your clients are not aware of the amount that they must send you. If you consistently mismanage your invoices, you may want to consider using invoice management software so you can manage your accounts better.
How to prevent late payments in construction
Build and sign robust contracts
One way to address the perennial issue of late construction payments is to make sure that the contracts you sign are robust, especially in terms of payment terms and schedules. If anything in the contract is vague and unclear, reword the language so it explicitly states when and how much you must get paid.
Implement effective trade credit policies
Construction companies that extend trade credit to clients must have an effective trade credit policy in place. A good trade credit policy is one that aligns with your company values and one that standardizes how you set appropriate credit limits that minimize the risk that you take when extending credit to your clients.
Serve preliminary notices and lien waivers
Preliminary notices can help you become more “visible” in a construction project, while conditional lien waivers encourage your clients to pay quicker. When you serve a preliminary notice, you open communication lines between you and the higher-tier parties. When you serve a lien waiver together with an invoice, you communicate your willingness to waive your lien rights as long as you get paid.
How to evaluate construction client risks
When evaluating your clients for potential risks, you can watch out for the following signs:
- Missing the payment scheduleDelayed payments are often an indicator that your client is not in stable financial condition, but it can also mean other things. They may have issues monitoring your progress on site, which can lead to major payment disputes.
One action plan that you can immediately do when a client misses the payment schedule is to set a meeting with them and clarify the reasons for late payment. You may need to revise the Schedule of Values if further negotiations become necessary.
- Excessive number of change ordersChange orders are not uncommon in construction, but you must stay alert when change orders become excessive. When left unmanaged, numerous change orders can lead to major payment disputes and disagreements down the road.
Ensure that you have a streamlined process for dealing with an excessive number of change orders. This means that you should be able to send notifications on time and update the timelines and cost estimates accordingly.
- Directing you to “not put things in writing”It is possible for some clients to require that you “not put things in writing.” This can be a sign of a major problem with budgeting. When this happens, you can ask the client to put the directive in writing, so you have proof that it was the client’s idea.
If a client refuses to formalize the directive through writing, you can go straight to the property owner or the construction lender. The higher-tier parties may ask your client to confirm the directive. Still, you must make sure that all items stipulated in your contract are recorded in writing.
How to minimize risk using construction contracts
Outline realistic and reasonable timelines
A contract must mention in detail the specific project timelines of a project. The details must include expected completion dates as well as progress milestones, and the proposed timelines must be realistic and reasonable. If there is anything in the proposed schedule that does not seem doable on your end or on the part of the client, be sure to communicate the issue and settle them before the contract is executed.
Clarify cost estimates and payment terms
A robust contract should also include reasonable cost estimates and payment terms, and these estimates and payment terms must be agreed upon by both parties. The payment agreements must also specify the applicable penalties for late payments. This will serve as protection against late payments, and it may also minimize the risk of non-payment.
Include change order and warranty agreements
Almost all contracts have sections that address the management of change orders and warranty requirements. It is important to include these provisions to ensure that everyone is aware of what to do in case there are changes in the scope of work and also to ensure that everyone understands the quality of work expected by the property owner.
Best practices for construction client risk assessment
- Do not be afraid to ask the hard questionsAsking and answering questions about your client’s finances is not always an easy task. If you are vetting a potential construction client, for example, it can be difficult to ask them what their financial status is and where they source their funding. You might come off as if you are prying into their business, and the negotiation might not go as smoothly if you do not ask your questions properly.
This is not a reason to completely forego asking the right questions and to just take your client’s word at face value. Let them know that it is part of your business policies to ask for financial statements and a list of references so you can conduct adequate research and offer the best terms and services to your clients.
- Review all schedule submissions and changesChanges in schedule and scope of work can frequently happen throughout the course of a construction project. For instance, the designers may have missed a detail on-site when they came up with the project design, which will require additional work for the contractors and material suppliers.
The changes must be monitored as they will often result in additional costs and possible deadline extensions. When you get notified about changes in the scope of work or in the project schedule, be sure to thoroughly review them. Make sure that you understand why the changes are being implemented and what your liabilities are regarding these changes.
- Ensure you have effective credit policies in placeIt is imperative that you have a standard policy for accepting new clients and for setting appropriate credit limits, especially for material suppliers. Without a robust trade credit policy, you might end up signing high-risk clients, and you might lose money in the long run.
A good trade credit policy specifies how credit managers must assess client risks and how late payments must be addressed. Standardizing these processes is necessary to mitigate major financial bottlenecks due to late payments and to allow you to focus on performing top-quality work instead of worrying about pursuing payment from delinquent clients.
- Protect your payment rights just in caseThere is no fool-proof way to eliminate all the risks that come with working on a construction project. You can minimize the risks, but it would be very difficult to assume that you have everything under control. This is why you must protect your payment rights just in case.
Construction participants have the right to recover payment by filing a mechanics lien. In most states, filing a mechanics lien may only be done by parties who have served preliminary notices and notices of intent to lien. Make sure that you meet these notice requirements to preserve your lien rights in case you ever need to exercise them.
Further reading