Can Factors and Surety Work Together?

Based on reports and surveys from around the country, public sector construction is experiencing modest growth. The not-so-great news is that conventional sources of credit for contractors are still scarce. Although considerable turbulence and change have occurred during the past several years, two constants in the public sector construction industry remain: Contractors need access to credit for working capital in order to participate in public sector projects, and contractors at all levels need an adequate bond capacity with a highly rated, treasury-listed surety, for which access to credit and/or working capital is essential to qualify.

Many, if not most, small to midsize contractors that have survived the recession continue to be tight on cash, having worked through whatever cash reserves they may have had after experiencing several years of losses. Although they have the capacity to perform excellent work, this financial situation places them in a poor position to qualify for a bank line of credit or for bond capacity. In many cases, both their bank and the surety have informed them that they no longer qualify for the credit facility they require to stay in business, or the facility they now qualify for is considerably smaller than their current requirements demand.

An additional market for both credit and bonding are new contractors that have come into the industry to fill the void left by the 25 percent of the companies in the industry in 2008 no longer working in construction. Although many of these new contractors are qualified to perform profitable work, their lack of years in their new business entity makes it impossible for them to gain access to either credit or bonding.

This situation presents an additional challenge to the general contractors (GC) that are working on publicly funded projects and have mandates, often with attractive incentives, to use on their projects a large percentage of subcontractors who are small, minority, disadvantaged and/or whose owner is service-disabled. The contractors they select must meet the participation requirements and have both the working capital and bonding capacity to fulfill their obligations under their subcontracts, so the absence of both working capital and bonding places additional strain on the GC’s financial and bonding capacity.

A solution is available that requires two extenders of credit—surety and factors that specialize in construction—to “step out of the box,” understand each other’s idiosyncrasies, and establish criteria to work together to provide the working capital and bond credit small- to medium-size GCs and subcontractors need to compete in today’s market. By definition, a factor that specializes in construction is a third party that purchases and agrees to pay a company’s invoices on progress or billed projects (minus fees) for the purpose of advancing funds through a funds control program to pay job costs on a project. Both surety and factors must understand the nuances and legal structure of each other’s businesses to realize that they can work together without violating each other’s collateral requirements to achieve the common goal of providing working capital to cover job costs—particularly payroll—while the contractor is waiting for payment of their invoices. At the same time, this partnership can provide bonds that guarantee performance on the project and the payments of subcontractors and suppliers.

Thorough Underwriting

The first step in ensuring the success of this program is thorough underwriting. The surety and factor will evaluate the contractor’s character, credit and capacity. The character of the principals of the company is evaluated by reviewing their personal credit history and tax returns, checking references and evaluating past performance. Corporate credit is evaluated similarly by, as a minimum, reviewing the past three years and year-to-date 
financials and tax returns, as well as current accounts payable and accounts receivable aging summaries; running corporate searches to ensure they are viable legal entities; determining who, if anyone, has filed liens on the company; and checking references.

A major difference between the surety and the factor in the financial evaluation of contractors is their reaction to the availability of working capital. If the contractor has adequate working capital through cash on hand or access to an adequate line of credit—which usually amounts to a ratio of at least 10:1 project size to available capital, depending on the size and complexity of a project—and all other criteria are acceptable, the surety will usually approve the contractor for bond credit with minimal conditions. In that case, the contractor will not have to employ the services of a factor.

If the contractor lacks what the surety considers to be an adequate amount of working capital, the surety may require that the contractor provide collateral in the form of cash or an irrevocable letter of credit (ILOC), use funds control or both before issuing bond credit. In this case, if the contractor employs the services of a factor working in conjunction with the surety, the factor will be able to provide the working capital and the funds control so the contractor is not required to provide collateral or otherwise be 
disqualified for bond credit.

The factor will also require other qualifying conditions that will allow it to continuously monitor the contractor’s financial health. The factor may employ a tax service to monitor the contractor’s tax payments and require the contractor to employ a payroll service that provides an HR function to ensure taxes are paid in a timely manner and that the contractor is in compliance with all current employment laws, rules and regulations.

The capacity of the company to perform the work is determined by thoroughly reviewing profitability of the company on previous projects, checking all of their references and contacting previous project managers of recently completed projects to determine their effectiveness.

Initial Plan Review

Once underwriting is completed and the contractor is approved for both a factoring facility and a bond capacity, the next step before a bond is issued or factoring for a project is approved is to evaluate the project through an initial plan review. This step ensures that the contractor has adequately estimated the project, has the capacity to perform the project for both the estimated costs and in the time required and that the project owners and/or GCs have the financial capacity to complete the project. The factor usually performs the evaluations of the financial capacity of project stakeholders. Once this phase has been successfully completed, the project is approved for factoring and bonding and is entered into the funds control system.

Funds Control Program

The generally accepted definition of funds control is that it is the outsourcing of accounts payable by the contractor to a third party to provide a high level of assurance to projects owners, contractors, surety and lenders that project proceeds will be used to pay project expenses before they will be used to pay any other expenses. The surety mandates the use of this service to accomplish the above as a condition of issuing both payment and performance bonds. The factor mandates the use of this service for the same reasons and advances all funds through the funds control program to ensure funds are only used to pay job costs in accordance with the project’s budget.

The funds control processes for both the surety and the factor are similar. The third party enters all of the project information into their construction accounting system, including the project cost, schedule of values, information about all subcontractors and suppliers and the project construction schedule. A separate escrow account for the contractor for each construction project under funds control is established so no co-mingling of funds occurs and the third party can make project expense payments in the name of the contractor.

In each case, as a new project is set up in the system, the third party—working through the client contractor—will require the owner or GC to acknowledge in writing that they will forward all payments to the third party rather than give the payment directly to the contractor. Concurrently, the contractor agrees in writing that, if they receive payments directly from the owner or GC, they will immediately provide that payment to the third party or be subjected to additional costs or legal fees.

The major difference between the third party acting on behalf of the factor and the surety is that, in the case of the surety, the third party waits for payment to be received from the owner or GC to pay job costs. In the case of the factor, once the contractor submits a pay application for periodic payment to the owner or GC and the owner or GC verifies that they have accepted the work performed and will pay the amount of the pay application, the contractor is able to “sell” the pay application or invoice to the factor. The factor will then advance funds to the third party through the funds control escrow account to disburse funds to pay job costs on the project, allowing the contractor immediate access to funds for job costs rather than waiting 40 to 60 days or more to receive payment.

Periodic Project Inspections

Throughout the course of the project, the factor will schedule a series of periodic project inspections to ensure that the work is being performed to the satisfaction of the GC and/or owner in accordance with the project plans and specifications. The site visit will be used to verify the use of budgeted material, ensure compliance with safety standards and provide all parties with a periodic report of the status of the project. The number of inspections will vary based on size, complexity and length of a project. This information is transmitted to both the factor and the surety to ensure that all risks related to the project are being managed properly.

Sharing of Collateral

The final piece of this puzzle is whether the two extenders of credit are able to share their interest in the most important collateral in the transaction: project receivables. In order to “purchase” a receivable to pay job costs on a project, the factor must have a first position lien on that receivable, a position provided by filing a UCC-1. The surety that has issued the bonds on a project has an implied first position on the receivable by legal precedence, whether it has filed a UCC-1 or not. Because the factor is paying project expenses with the advance generated by the purchase of the invoice and reporting all project expense payments to the surety on a regular basis, no conflict should exist. By completing the initial plan review, determining that adequate funds are budgeted for the project and monitoring the financial management of the project through the funds control program, both entities will be constantly aware of the financial status of the project and should be comfortable with the process.

Can factors and surety work together? Absolutely. The partnership requires coordination, cooperation and the effective implementation of all of the risk management tools at their disposal, but they can work together to provide additional credit and bond capacity for many more deserving small to midsize contractors.