Business Plans, Not Bonding Capacity, the Real Issue
Sureties would prefer to make a reasonable business decision that supports a contractor’s business plan and the bonding requirements of the plan rather than dictating bonding capacities to their clients.
“What’s my bonding capacity?”
Understanding and accomplishing these items will prepare any contractor to have a meaningful and productive conversation with their agent and surety concerning bonding capacity for individual projects and the aggregate program in general.
Throughout the years many contractors have asked me this question. Is it really a question a successful businessperson should be asking? Might it be more appropriate for the contractor to develop a business plan that encompasses his or her surety needs, then present that plan to the agent and surety for their concurrence?
Surety companies aren’t really looking to dictate bonding capacities to their clients. Nor are they looking to participate in bidding wars for prospects with bonding limits serving as the main ammunition. Sureties would prefer to make a reasonable business decision that supports a contractor’s business plan and the bonding requirements of the plan.
When developing a plan to share with a surety, it is important for a contractor to understand what segments of his business plan are of greatest interest to the surety. Prior losses and the reasons for those losses tend to shape the underwriting practices of the surety industry. Several of the key areas of concern that should be addressed by a business plan are covered below. They include territory of operations; size and type of work; profit margins; backlog and staff
One’s territory of operation is important because as the territory expands, so does the risk of loss. Expanding operations to a different city, county or state will generally require the contractor to become familiar with new laws, licensing requirements, subs, suppliers and competitors. Each of these instances increases the risk and potential inability to successfully complete the work.
If a contractor’s business plan illustrates aggressive growth in job size (perhaps a doubling or even greater growth), the contractor should be prepared to explain his thought processes. Most sureties become uncomfortable when asked to support bonds twice as large as anything a contractor previously demonstrated a proficiency to handle. The same scenario exists if the contractor attempts to venture into a new area of construction. Municipal projects – often consisting of sidewalks, curbs and gutters – will not provide a contractor the experience necessary to bid on TxDOT projects.
Likewise, if a contractor’s project history is full of schools and office buildings, he shouldn’t expect a surety to be ecstatic if he suddenly plans to start bidding on water treatment facilities or justice centers.
When it comes to profit margins, contractors need to be ready to outline plans that are realistic and attainable. A surety will compare a contractor’s projected margins against the historical results. Asking a surety to agree to a plan that illustrates a 15-percent gross profit margin for the next year will be difficult if the contractor’s historical results indicate average margins of 2 percent. Of course, this certainly isn’t out of the realm of possibility, but a contractor must be able to justify the projected results.
Backlog is everyone’s favorite possession. If a contractor doesn’t have much of a backlog, he needs to get one. If he has one, he needs to make it larger. The problem comes in deciding how much of a backlog to have. The truth is, too much of a good thing can kill a contractor.
Several years ago, I had a specialty subcontractor bonded on a multitude of projects. The company was averaging profit margins above 20 percent. But then came that dreaded phone call: Termination for lack of performance was pending on three different projects. After several meetings and schedule revisions, the contractor survived the potential flood of work. His comment to me the next year while reviewing his financial results was, “I never envisioned a time that my company would be at risk because I had too much ‘good’ work. That will never happen again.”
It’s important for contractors to analyze their projected backlog. Is it consistent with the previous history of success? Does it provide a practical revenue flow? Is the right amount of people and equipment available to successfully perform the work without assuming too much debt? Project managers, superintendents and job site workers are all essential to completing work in a profitable manner. A contractor’s project management team should be experienced and thoroughly understand their company’s way of performing work.
In conjunction with the review of a contractor’s business plan, a surety will review the contractor’s financial results. The surety will perform a detailed analysis of the contractor’s entire financial report encompassing several years of results. The components of the balance sheet will be examined and the surety will determine which of the specific items will be “allowed” as viable assets in the analysis. Most sureties will “disallow” certain assets if they feel the asset may not be valid. Examples of assets the surety might disallow are accounts receivable older than 90 days, billings for unapproved change orders, large under billings and inter-company receivables.
Upon completion of the financial analysis, surety officials will formulate an idea of the size of single-project work and backlog that they feel the financial statement will support. As a general parameter, the surety will consider backlogs in the range of 10 to 20 times analyzed working capital. Keep in mind that this range is simply a starting point. Deviations from this general bonding range will be determined from the components of the contractor’s business plan. Increased risk – such as a broadened work territory, changes in the type of work selected for bidding, and projected growth in individual job size and backlog – will all cause the surety to look toward the safer range or lower multiple of the contractor’s working capital.