The last edition of Surety Corner introduced the topic of bond limits, what might be holding back a contractor’s growth and the general areas of focus to ensure you are maximizing your bonding limits.
The example we had used was contractor XYZ who had $500,000 in working capital, which translated to a $10 million aggregate bonded work program based on 20 times leveraging. However, XYZ is looking to take on a larger job and to fit this project into their backlog they need to increase the aggregate limit to $12 million.
As a refresher, working capital is cash plus receivables less current liabilities (trade payables, wages payable, taxes, current portion of debts, etc.).
So, based on the above scenario what options does contractor XYZ have available to boost working capital and ensure they have the adequate limits available?
Using capital to increase your bonding capacity
The most common, easiest and quickest approach to increase working capital is a solution known as a capital injection. In the scenario described above and using 20 times leverage of working capital, contractor XYZ requires a minimum of $600,000 in working capital to achieve a $12 million aggregate. With a current working capital position of $500,000, XYZ will need to add another $100,000 in working capital.
With a capital injection, the owners of the construction company would inject $100,000 in cash into the business, usually via a shareholder loan and subsequently subordinate that amount to the bonding company.
The subordination is a formal agreement that allows the loan to be treated as equity and working capital with the contractor agreeing to leave those funds in the company to support the business. These funds can be utilized by XYZ to pay for business expenses (trade payables, wages, etc.).
What if the owners of XYZ don’t have the cash available to inject into the business?
If the owners of XYZ do not have the cash or prefer not to loan the company this money, then we will need to look at ways of organically increasing working capital. XYZ has borrowed $100,000 from its operating line of credit, which is negatively impacting its working capital position.
In order to boost working capital, contractor XYZ chooses to approach their operating lender and asks them to consider “terming out” this debt. This means that rather than the debt being considered current debt and repayable on demand, the bank agrees to structure this debt as a term loan paid back over multiple years.
In this case, the bank agrees to let XYZ repay the $100,000 debt over five years so the current portion owing is only $20,000. This results in a net increase in working capital of $80,000. XYZ now has $580,000 in working capital, so now a much smaller capital injection of $20,000 bring them to the $600,000 required.
Turning over receivables and updating your bond company
Receivables are another area that could be dragging down your working capital. Many surety companies will look at receivables over 90 days and discount those from working capital as they consider it doubtful that these amounts will be collected. Ensuring that you are following up on aged receivables and identifying to the bonding company which items are holdback (holdback is included in current assets and thereby working capital) will ensure you are getting the most credit you deserve.
XYZ has $500,000 in receivables but $100,000 of these are over 90 days so the bond company has discounted this amount from the working capital position of XYZ. Once investigated it turns out that $50,000 of this collected last week and the other $50,000 is holdback payable in three weeks. With this good news, the bond company credits the $100,000 back to the working capital position of XYZ.
Using capacity to increase your bonding limits
Ultimately, most surety companies are financial entities are heart. The majority of people working at surety companies are accountants or finance experts by trade and most do not have a formal education in construction. As a result, a contractor and their broker’s ability to clearly explain the contractor’s operations is critical in boosting limits and securing that stretch job. Doing this effectively can sometimes allow a contractor to increase the bonding capacity without increasing capital right away.
A good example of this is contract structure. Many contractors will sign lump-sum construction contracts such as the CCDC 2. However, many also utilize different contract structures like construction management such as the CCDC 5B. The difference in risk between a lump-sum contract and a construction management contract where the owner signs the contracts directly with the trades is substantially different. In the construction management (not at risk) scenario the risk of a subtrade default or dispute is moved to the owner. Explaining this risk clearly and how much of a contractor’s backlog is not at-risk can allow for additional leveraging.
Part 3 of our Is your bond company slowing your growth series will examine additional tips and tools that can be utilized to ensure your bond company is not limiting your potential.
Jamie Collum is the vice-president of construction for FCA Insurance. He has delivered numerous seminars and presentations on construction bonding and general industry updates in Ontario to various construction associations over the years. Andrew Cartwright is the vice-president of surety for FCA Insurance. With over 10 years of experience as an RVP of a large national surety company, Cartwright uses his expertise to help FCAs clients manage and build their surety capacity.
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I really like this series and am looking forward to Part 3. Thank you!