9/4/2014 Why Contractors Fail | Risk Management

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Why Contractors FailBy Hugh Rice & Arthur Heimbach Published On: Tuesday, September 2, 2014 9:55 AM

ecent history has shown that construction firms are not too big to fail even thoughthey may have annual revenues ranging from hundreds of millions to several billionsof dollars.

While there are bonding safeguards to protect project owners and others when acontractor fails, there are no such safeguards for the contractors themselves. Suchan event affects not only the employees and shareholders of the firm that fails, but

also the industry as a whole. During the past few decades, there have been dozens of largecontractors that, after many years of growth and apparent prosperity, experienced notablefinancial disasters, resulting in bankruptcy or a reincarnation of the business in a muchdifferent form.

WHY DO SUCCESSFUL CONTRACTORS SELF-DESTRUCT?The industry has regularly witnessed smart leaders making what appear to be the samefatal mistakes others have made before them. Frequently cited mistakes are:

STRATEGICUnrealistic growth, over expansion, unfamiliar new markets or entry into new types of

constructionVolume obsession

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Unrealistic promises, bad contracts or poor project selection

ORGANIZATIONALInsufficient capital or profitsLack of business knowledge, poor financial management, poor sales skills or inadequate

marketingPoor leadership or poor leadership transferProject losses or poor field performanceOwner court battles or owner bankruptcy

UNCONTROLLABLEIndustry or economic weaknessBanking and surety changes

While helpful, this list of mistakes provides insufficient clarity regarding the causal roots offailure. In order for firms to have stronger preventive guidance, leaders need to understandthe causes behind the causes. There are four major categories.

GENERAL ECONOMIC CONDITIONS

Specific economic forces affect contractors through many paths, including bonding issues,demographics, government policy, tax law, consumer confidence and even materialshortages. For example, contractors may blame their financial disaster on a lack ofavailable work due to a suppression of construction plans that is caused by an increase ininterest rates. The fact that not all contractors fail during difficult economic times indicatesthat there are other, more relevant causes. In fact, many seasoned industry executivesemphatically reject the notion that luck or other extraneous forces are responsible for acompany’s decline. Nonetheless, research indicates that these external factors quicken thepace of demise for companies that suffer in other areas of concern.

THE NATURE OF THE CONSTRUCTION INDUSTRYMany of the characteristics that are unique to the construction industry are keycontributors to a contractors’ financial difficulties.

Leverage. Leveraging working capital or leveraging equity is what is meant by “leverage”in the construction industry. High leverage for contractors typically refers to the amount ofrevenue pushed through the pipeline compared to the underlying equity base or level ofworking capital. Contractors, especially in the building market, can do a large amount ofbusiness with a little bit of equity.

Workforce issues. The construction industry is a people business, and without the rightpeople in the right places, contractors are bound to get into trouble. Where are thesepeople going to come from, and where will a construction firm find technically qualifiedpeople to do the work in the pipeline now and in the future?

The cyclical nature of the industry. Construction activity rises and falls faster than theoverall economy. Such fluctuations lead to being over-committed or scrambling for work tokeep people busy. Both can lead to problems.

The hard-bid process. The way work is procured in a large part of the constructionindustry is different from the way most businesses work. The owner wants a building andwants to know exactly how much it is going to cost before the project is built. Increasingcomplexity of projects, fluctuating materials costs and labor concerns all conspire to makethis a dangerous get-work practice for contractors. While the predominance of this methodis changing with new delivery methods, it is easy to see how contractors still get intotrouble here.

Project timing. Dictated by owners’ schedules, contractors have little control overproject start dates. Sometimes project opportunities become available at the same time,leading to over-commitment of company resources. In other cases, project start dates slip,creating staffing and financing challenges for the contractor. Backlogs can fluctuate widely.A related issue is long project durations, which can result in project impacts due tomaterial, labor, weather and related issues.

THE EDITOR

Marla McIntyreFor more than 25 years, Marlahas educated contractors,subcontractors, bankers, publicand private owners, legislators,educators, insurers, andattorneys on contract surety

bonding and construction issues. She’s the author ofmore than 100 articles, including an award-winningseries for the Risk Management Association, and haswritten books, directories, informational brochures,and reports. Her extensive construction and riskmanagement background includes stints as executivedirector the American Subcontractors Association ofMetro Washington and the Surety Information Office.She also worked for Associated General Contractorsof America, National Conference of States on BuildingCodes & Standards, Association of Major City BuildingOfficials, and National Concrete Masonry Association.She served on the boards of the Construction WritersAssociation, and American Council for ConstructionEducation and was active in the Construction OwnersAssociation of America.

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Derived demand. Most businesses think they have the ability to affect the demand fortheir service or product. If a company wants more business, then it conducts moremarketing to create the demand for its product or service. On the other hand, contractorsare always responding to opportunities. Ninety-nine percent of the work done in theconstruction industry comes from contractors responding to available work. Therefore,contractors are at the mercy of the work that comes their way.

The hyper-competitive construction industry. Construction is an easy business to getinto; low barriers to entry and price-driven competition lead to a very competitive industry.In addition, when every project is unique, contractors don’t get to practice. The learningcurve can be expensive and not all learning is portable to the next project.

CULTURE AND SYSTEMS OF THE ORGANIZATIONCorporate culture issues have gained recognition in recent years as being more importantthan historically thought. This area is especially notable when clashes in corporate cultureare cited as leading to a company’s end. Ethical and moral issues are some of the moreserious areas of corporate culture failures, but a company’s culture also affects decisionsabout its strategy and hiring needs. The strength of the company’s culture dictates not onlyits ability to hold firm on the practices needed to maintain a financially disciplinedorganization, but also its capacity to change and meet the evolution of the market and thecompetition.

Financial discipline. Some contractors are not good business people. They are goodbuilders, but they don’t give the financial side of the business the attention it deserves. Lackof financial discipline generally means the business is not being managed like a realbusiness. For example, at some firms the financial people aren’t involved in decision-making; instead, they are relegated to bookkeeper status with the thinking that the onlyreal work of a construction business is construction.In addition, companies that do not maintain adequate capital reserves are running on therazor’s edge. One misstep can cause them to fall into a cycle of failure. This managementaspect is a critical area that affects the long-term sustainability of a contractor. It is oftensabotaged by other corporate and personal demands, leading to the company’s demise.

Decision-making. Many contractors do not have a well-defined process for makinggo/no-go decisions when deciding whether to take on a project. In a highly competitivebusiness, one bad project can mean an unprofitable year, or worse.

Succession planning. Ensuring that a strong leader is replaced with another strongleader when the time is right assures the continuity of the business and future growth. Thisdoes not happen often enough in the construction industry.

Innovation. There is often a sense that construction is a business that never changes. Ifthat was ever true, it isn’t anymore. Innovation is required to win work and to build itprofitably.

Strategic planning. Many construction companies do strategic planning, but don’t havevery good strategies. They tend to be so caught up in the process that they forget that theirtask is really to determine what kind of company they are and where the company shouldbe headed. Instead, their “strategic” planning becomes an operational fix-it list.

THE MIND OF THE CONTRACTORMost contractors are by nature driven to grow their business. They want to build thebiggest job or perform the most volume. They readily buy into the “if you’re not growing,you’re dying” mentality. If the firm is public, the market expects it to grow. Part of thatexpectation is the belief that profits will grow along with revenues. In construction, thisresult is often not the case.

Additionally, contractors often are rapid decision-makers who sometimes act too quicklywhen a more deliberate approach is needed. Most leaders in the construction industrycame from the operations side of the business. While this is a critical background for aconstruction executive, the CEO’s job is to run the business, not the projects. A projectfocus to the business can lead to a feast or famine mentality. Getting the next project andbuilding the backlog seems to overshadow all other considerations — frequently leading totaking the wrong job for the wrong reasons.

In addition, construction is a high-risk industry, so it is not surprising that those whoventure into this business are numb to its inherent risks. Many people outside the industryconsider it crazy that contractors would assume such risk compared to the low margins

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gained. Yet, the people running construction companies don’t see it that way. Instead, theysign personally for bank loans and bond guarantees thinking it is “no big deal.” They believethey can control the risks. They have strong egos and a can-do attitude. This supremeconfidence can be a great characteristic for a contractor, but it also can lead to the downfallof the business.

These four major causes are a result of some critical root causes. A deeper look at whycontractors fail, including an examination of the chain reaction failure model in action, is inFMI’s white paper, Why Contractors Fail: A Causal Analysis of Large ContractorBankruptcies.

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Hugh RiceHugh Rice is senior chairman of FMI Corporation. He created the firm’s Mergers & AcquisitionsGroup, now FMI Capital Advisors, Inc. His expertise and experience in stock valuations, ownershiptransition planning, merger/acquisition advice, and strategy development for business in theengineering and construction industries has made him an Internationally sought speaker on theconstruction industry including being interviewed for MSNBC’s Money Watch. He may be reached at303.398.7223 or via e-mail at hrice@fminet.com.

Contact: Email Website

Arthur HeimbachArthur Heimbach, Ph.D. is retired from FMI. Contact: Website

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