How Subcontractors can Avoid Financial Distress

A combination of macroeconomic factors and a desire to drive top-line revenue continues to lead many subcontractors to underbid projects, sometimes unintentionally, ultimately contributing to financial distress. As more subcontractors succumb to the pressures of the environment, we may see a bubble form.

Savvy general contractors are already taking steps to protect themselves from the impact on their projects and bottom lines, but subcontractors need to seize this moment of uncertainty to right-size their operations for long-term success as well and prepare for the level of scrutiny they’ll face as leading general contractors vet future subcontractor partners.

Mounting Pressure

The Associated General Contractors of America 2024 survey found that 70% of respondents reported more subcontractors are in distress, or defaulting, compared to a year earlier. The same survey found that approximately 50% of respondents said they had experienced project delays or cancellations because of subcontractor defaults.

One year later, the landscape remains challenging and continues to tamp down demand for construction projects, especially for new homes, leaving even fewer project opportunities up for bid. A few factors at play:

• Many subcontractors felt some relief when the Federal Reserve started cutting interest rates last year. However, the rate cuts thus far and those anticipated in the short term are too little too late to drastically reverse demand trends.
• Subcontractors that used COVID relief funds to keep their businesses operational over the last several years have likely depleted the reserves that kept their businesses afloat.
• Labor issues are creating additional challenges as older workers leave the field and organizations are forced to hike their wages to find new talent. This and other factors could create a long-term contraction of the available talent pool, which only drives up real project costs.

Stretching Themselves Thin

Like all companies, subcontractors face constant pressure to leverage their labor and equipment to drive revenue for their businesses. However, with the aforementioned sustained economic headwinds driving down the amount of available work in the broader construction market, some subcontractors are intentionally underbidding contracts to keep employees and equipment utilized while they wait for conditions to improve.

In other instances, underbidding or poor estimating is the result of a lack of the right data and analysis. For example, a subcontractor might not appropriately account for labor and material cost inflation in estimates. Alternatively, a subcontractor that specializes in one area with weak demand – housing for example – might bid on projects in the stronger commercial and/or civil construction arenas to sustain business. However, they may underestimate the costs simply because they are not familiar with the unique dynamics of a project outside of their traditional scope or specialty, or the complexities involved with completing it.

Deeper Look Under the Hood

Regardless of why a project was underbid, it can create serious cashflow issues, which in turn, harms general contractors and their ability to complete projects on time and at cost. If a subcontractor simply cannot complete the project due to insolvency, it can also leave the general contractor under pressure to quickly find a new subcontractor to finish the work.

Therefore, savvy general contractors are fortifying their subcontractor bidding processes and taking a deeper look under the hood of subcontractors. Increasingly, they are:

1. Setting stricter criteria regarding who is allowed to bid for contracts and limiting bids to those subcontractors who have the financial resources to complete the work. In some instances, contractors are engaging consultants to review the financials of subcontractors bidding on work for clues of distress. Signals such as unexplained billings in excess of costs on the work-in-progress schedule could be a sign that the subcontractor might be experiencing liquidity constraints requiring them to advance bill to fund working capital needs.
2. Deepening the due diligence on potential subcontractors. References are increasingly a part of the bidding process to ensure recent and existing projects are on track and that there is expertise in the construction subspeciality where work is needed. This is true even where there is an existing relationship.
3. Contracts increasingly contain clauses that require subcontractors to obtain payment or performance bonds, which can protect a general contractor against loss if a subcontractor defaults. Similarly, general contractors are also protecting themselves with subcontractor default insurance.
4. To help identify signs of distress, subcontractors are also being asked to consent to regular inspections by owner representatives and in-person check-ins with the general contractor. Many are also establishing formal systems to track progress such as monthly percent complete reports and 13-week cash flow forecasts.

Fortifying Bidding Processes and Financial Footing

To prepare for this increased vetting and to protect their organization’s long-term success, subcontractors need to use times of excess capacity to analyze their existing processes, operations, and financials.

First, subcontractors can avoid some risks by strengthening their costing and estimating process and utilizing pricing models used to draw up bids. This includes taking stock of component and material costs at the time of bids and speaking with existing suppliers to understand how those costs could potentially increase over time. Will prices be adjusted in the next quarter for inflation? Or will new tariffs impact the price of the material?

In addition, subcontractors should revisit their vendor lists regularly to ensure costs remain in check. A regular review of vendors and supplier contracts might reveal negotiation opportunities for materials and components needed at scale. Subcontractors should also cast a wide net with potential vendors to obtain the best price for required project inputs that can improve the bottom line on projects.

It’s not uncommon for familiar vendors and old price lists to be used in bidding processes, but taking these extra steps can help to ensure bids are more accurate and the subcontractor’s own margins are protected. Keep in mind that although margins remain vital, savvy general contractors are starting to recognize that they might jeopardize projects when only awarding contacts to the lowest bidders.

Similarly, labor costs need to be evaluated regularly to ensure that bids consider changing market conditions for the specialty and don’t underestimate the costs for the various skills needed for a particular job. This includes understanding expenses and anticipated changes in labor costs, considering wages, benefits, and the impacts of anticipated bargaining agreements in instances where union labor is utilized. Furthermore, because many subcontractors are closely held entities, many keep family members on the payroll, often at a very high rate of compensation that can be detrimental to the long-term viability of the business.

In tandem with an evaluation of labor and supply costs, financials should be holistically evaluated. This should be done to:

• Understand where there are additional costs that can be mitigated. Travel and entertainment expenses used to secure business are often an area where costs can be scaled back.
• Ensure subcontractors can respond to rising vetting and reporting requirements.

A deep look at financials should also include an evaluation of cash flow and liquidity tools to help avoid some of the business stressors that encourage underbidding. This helps subcontractors gain a strong understanding of weekly cash receipts and disbursements and can be used to guide decisions on how to use cash on hand especially when struggling through a period of low liquidity. Ensuring a strong understanding of working capital – which requires the ability to report on it accurately – will dually prepare those subcontractors who have loans for the additional scrutiny that they may face from their bankers as the market continues to tighten.

Positioning Businesses for Long-Term Viability

There is no denying the increasing amount of competition subcontractors face – and will likely continue to face for the time being. However, there are steps they can take to separate themselves from the competition and help overcome the current headwinds. By doing deeper due diligence and more actively managing contracts and labor, they can help ensure their businesses remain strong over the long term.