FIM 2012

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INTRODUCTION

• Before one can define how to save a financially troubled contractor, one must define what a financially troubled contractor looks like. Contractors get into trouble in good times and bad times alike. Why is that? Since 1964, the commercial construction market has seen relatively small overall growth, whereas the number of contractors over the same period of time has grown substantially. Refer to the figure below.

• The resulting effects are that an ever-increasing contractor base is competing for a small-growth marketplace. Contractors, therefore, are prone to reach beyond their financial capability to keep the work volume up. The consequence is a fertile arena for creating financially troubled contractors.

WHAT IS THE "REAL" PROBLEM?

It is important to understand why contractors fail. The short answer is usually mismanagement.

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The following is a brief overview of internal and external factors that, while are controlled by management, are critical to creating a troubled situation. They are as follows:

• Uncontrolled or mismanaged growth• Lack of timely and accurate financial information• Deteriorating business• Cash flow challenges• Communication breakdown• Lack of early problem detection• Lack of focus

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Management is predisposed to blame the misfortunes of the company on external factors that would appear to be beyond their control rather than to be held accountable and correct the situation. The following are some of those external factors:

• The local construction economy was slow;

• The bank refused to extend additional credit; and

• The competition is bidding too low.

• The truth is often quite different. Many contractor troubles are the result of owners or company executives who have lost their focus or lack the ad- equate management skills. The skills and talents that it takes to start and develop a successful contracting business often differ significantly from those required to maintain or grow the same business.

• While external factors certainly play a part, the chief executive officer (CE0)/owner and other company executives must analyze whether more fundamental conditions are responsible for the distress. Few problems in the external environment are sufficient by themselves to cause a financially troubled situation for a well-run contractor.

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WHY ARE CONTRACTORS SUSCEPTIBLE TO TROUBLE?

• The construction industry is in fact a cyclical industry, which simply means that the revenue will rise and fall depending on outside or external forces. The most likely organizations to withstand this cyclicality will be the ones that learn to adapt.

• The Turnaround Management Association lists certain organizations as being more susceptible to trouble than others. That list is as follows:

– Service-oriented industries– High-leveraged companies– Closely held businesses– Family-owned businesses– Companies lacking a proprietary product

With respect to the list above, where do you think construction falls? In many cases, a contractor will fit all of the identified categories.

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WARNING SIGNS: HOW DO YOU DIAGNOSE TROUBLE?

• "What are the warning signs of a contractor that is heading for or is in trouble?" is a question frequently asked by banks, sureties, and suppliers. "How can you tell when a contractor is getting into trouble?"

• Trouble comes in many forms for a contractor. It is extremely important to remember that the obvious signals are rarely the root cause of the problems. A significant loss on a project, for example, is not the problem but, rather, the result of a number of problems.

• The warning signs listed below are by no means inclusive, but they provide some very specific insight into why a contractor may be facing difficulty

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Signs relating to a contractor's financial performance include

• Decrease in available cash• Consistently out of compliance with bank covenants• Cost in excess of billing at or greater than 150% of billing

in excess of costs• Booking change orders without proper approvals• 25% of accounts payable consistently running over 160

days• Gross margins decreasing while the backlog of work is

increasing

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Signs associated with a contractor's operational performance include

• Inability to forecast job status at 15% complete

• Recognizing substantial portion of claims without documentation or substantiation

• Writing accounts payable checks and holding them in file• Delays in submitting financial statements to lenders, suppliers, and

sureties• Declining revenues per employees• Generally low employee morale and performance• Trade credit difficulties, cash before shipment of material, or credit

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• Large quantities of claims• Recording greater percentage complete than appropriate • Communication breakdown between groups within the contracting

firm • Lack of an effective cash flow system• Lack of ability to recognize "committed costs" within the work in

progress• The organization has been reaging accounts receivable• Shifting costs from one job to another• Delinquency in tax payments

These are merely symptoms, not the problem itself. These symptoms are confirmation that a significant problem does in fact exist, and it is the problem, rather than the symptoms, that must be identified and resolved if the contractor is to be turned around.

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HOW DOES THE TURNAROUND HAPPEN?

In general, there are some very significant questions that must be answered quickly before the turnaround plan can be developed. The operative word here is quickly.

In the process of gathering information, the turnaround leader must ask the existing management the following questions:

• What is the purpose of this organization?

• Should this business be saved?

• Why?

• Are the reasons valid?

It is quite possible that management has never stopped to think about these questions before. In evaluating the answers received in response to the above questions, the turnaround leader must then consider the following issues :

• Can sufficient cash sources be found to aid the contractor through its recovery?

• Is this management capable of leading the company in the turnaround and beyond?

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• Is it feasible that this contractor can continue in business?• Is there, within this contracting firm, a core organization that can be

saved and provide the rootstock for the emerging organization

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The process of recovery involves several stages.Those stages are as follows:

• Discovering the facts

The turnaround leader must learn as much as pos- sible quickly to assess the extent of the situation. This entails the assessment of the cash position of the organization, analysis of the work in progress, identification of additional losses to be incurred, and evaluations of the im- pact on cash flow. This particular part of the turnaround process is so critical to the success of a turnaround that it cannot be emphasized enough.

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Analyzing the facts

There must be a detailed assessment of the current operations of the contractor. That assessment should include the following:

• Cash flow analysis• Legal assessment• Federal/state actions• Bond claims• Insurance assessment• Analysis of exposure both personal (owner) and

corporate

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• Preparing a turnaround plan that outlines possible courses of action

The turnaround plan must be written, must contain action steps, and must contain alternatives. Why? Because the owner/CEO, once highly independent and successful, suddenly finds himself or herself confused and out of touch with the needs of the organization. The skills and talents that were so effec- tive in launching and developing the business have now become ineffective in dealing with an internal crisis. So it is extremely important to get the owner's input on the course of action and at the same time obtain the buy-in that will be needed for the implementation of the plan.

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• Implementing the turnaround plan

Once the course of action has been agreed on, the turnaround leader must effectively build a team both inside and outside of the contractor. The outside team must include the bank, the surety, the major suppliers (trade creditors), and any senior debt holders. The inside team must be composed of the organizations group, estimating, engineering, construction, management, and finance/administration. It is criti- cal that all of these groups understand the entire situation. There are three very important principles to govern the teams. They are communication, communication, and communication.

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• Implementing the turnaround plan

Once the course of action has been agreed on, the turnaround leader must effectively build a team both inside and outside of the contractor. The outside team must include the bank, the surety, the major suppliers (trade creditors), and any senior debt holders. The inside team must be composed of the organizations group, estimating, engineering, construction, management, and finance/administration. It is critical that all of these groups understand the entire situation. There are three very important principles to govern the teams. They are communication, communication, and communication.

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• Monitoring the turnaround plan

It is extremely important to the success of the turnaround plan that the turnaround leader be accountable for monitoring the action items within the plan. An excellent way to accomplish this is to establish a "report card." The report card would contain measurements im- portant for, or even critical to, the success of the plan, such as the following:

• Bank line availability• Underbillings• Accounts receivable over 60 days• Overhead as a percentage of revenue• Working capital• Backlog of sales (revenue)• New work/month

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The Report Card

The report card should contain as a benchmark the values for the above cat- egories (these are by no means all of the potential measures) at the last financial statement at the beginning of the turnaround plan. The report card should also contain for the same categories the goals that are consistent with the turnaround plan. This report card should be made available to all individuals involved in the turnaround. The following is an example of a report card (dollars in millions):

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• The above process should lead to the immediate focus on cash flow since it is usually the shortage of cash that has identified the need for the turnaround and causes the initial trouble.

• Brief analysis of the available assets will turn up sources of quick cash infusion. This would also include the termination of operations that are not profitable and are draining the core business cash. These are difficult decisions and intrinsically will involve downsizing the company and eliminating some jobs. The net effect, however, will be to save the good parts of the company and many other jobs.

• Many, if not most, troubled contractors lose their creditability with lenders, sureties, trade suppliers, employees, and customers. The turnaround leader must be sensitive to this difficult situation and begin rebuilding damaged relationships immediately. The personal integrity of the turnaround leader will be a marked contrast to that of the existing management, which finds itself in the troubled situation.

• Above all, the turnaround leader must be an effective teacher, because critical to success of the ongoing management is their ability to know how they got into the position and how not to return to that position in the future.

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• Many, if not most, troubled contractors lose their creditability with lenders, sureties, trade suppliers, employees, and customers. The turnaround leader must be sensitive to this difficult situation and begin rebuilding damaged relationships immediately. The personal integrity of the turnaround leader will be a marked contrast to that of the existing management, which finds itself in the troubled situation.

• Above all, the turnaround leader must be an effective teacher, because critical to success of the ongoing management is their ability to know how they got into the position and how not to return to that position in the future.

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WHAT ARE SOME ROADBLOCKS TO A SUCCESSFUL TURNAROUND?

• The number one management problem leading to contractor failures is the inability to recognize and deal with problems early on. Even though it usu- ally costs money to develop a plan that will revitalize a troubled contractor, the cost of not doing so grows exponentially as time passes, as does the risk that the contractor will not be able to be saved.

• The tragedy of most contractor failures is that many of them could have been and would have been avoided if their problems had been recognized and acted on in an expeditious manner - construction company problems cause a downward spiral that, sooner or later, destroys the company. In a bad construction economy, the downward spiral usually comes, and the contractor who has failed to take definitive action early on is the first to fail.

• So, what are the hindrances to saving the financially troubled contractor? Most revolve around the owner and/or executive management. Many CEOs/ owners equate asking for help with admitting failure and very often will not ask until it is too late

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• Often, a troubled contractor, that has been in business for many years and wants help, places too many conditions on the help, so the turnaround leader is prevented from doing the job effectively. Consequently, the turnaround leader must be skillful in his or her approach to handling the delicate situation of saving the company while reducing nonperforming operations in which the contractor may have long-standing personal relationships with certain individuals within the organization.

• Ultimately, the success or failure of a turnaround rests with assets that are not recorded on any balance sheet or listed anywhere in the financial state- ments..

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CASE STUDY OF "ABC": A $20 MILLION CONTRACTOR

The Issues• After two years of losses and continuing cash flow challenges,

ABC's surety indicated that it was no longer interested in maintaining a bonding line. ABC, like so many contractors before it, had lost focus and begun to flounder.

• The acquisition of large amounts of leased equipment, no formal cash flow system, and a lack of focus on job progress (including an ineffective change-order system) contributed to what could be called "a slow path to suicide" for this contractor.

• In its field operations, ABC was second to none. And as a contractor, its reputation was second to none. The company's owners were always satisfied with the work product, which generally consisted of fast-track projects. The business of construction was not the difficulty the "business of business" was the challenge.

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The Problem Areas

• Leased and purchased equipment Over time, the CEO/owner had acquired a huge amount of costly equipment (both leased and purchased). Much of the equipment was lying dormant in the yard waiting for the big job that would soon be coming." In the meantime, lease payments coupled with repair and maintenance charges continued to be expended, with no revenue to cover these costs.

• The CEO/owner took the long-term view and thought he was building equity in this equipment. He said that, eventually, the equipment would be fully amortized and of significant value in bidding because it would lower equipment costs on particular projects. However, the cost of carrying and maintaining this large store of equipment developed into a huge financial burden

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• No cash flow system ABC did not use a cash flow system of any kind. The contractor figured that if he still had borrowing capacity on his bank line, his cash flow must be OK. However, the bank line (originally intended for operations expenditures) soon became a long-term committed loan that stayed at or near its available maximum.

A distortion in cash flow occurred because of the following:

• Neither the contractor nor anyone on his staff ever knew how much cash was actually available at any time.

• There were major purchase commitments of field material that had to be made.

• There were monthly expenditures for fixed and variable overhead that had to be met.

• The costs associated with all of the equipment (both leased and pur- chased) had to be met.

Because of the extremely high cost of interest, this distortion in cash flow exacerbated ABC's overall financial challenge and added to the monthly cash flow drain.

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• Inadequate systems to measure work in progress This contractor's efforts to measure the monthly status of his work in progress were rudimentary at best. Each job's progress was reviewed against original budgets, but projec- tions about cost to complete did not take place. The only time ABC knew it had cost overruns was when actual expenses exceeded budget. However, this information became available too late in the process to make significant modifications to any jobs in the field. In short, too little, too late.

• With this delayed system of project review, there was an inherent diffi- culty in ensuring that the conditions under which the project was bid matched the conditions that existed while the job was being completed. In other words, change orders were extremely difficult to monitor, and they were even more - difficult to deal with because they came at the end of the project.

• This was just where ABC found itself—at the end of a project with the owners satisfied and the contractor trying to negotiate changes to the conditions experienced in the field.

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The SolutionsThere was an immediate need to create a cash flow system that was

consis- tent with the actual sources and uses of cash experienced by ABC. Using cash flow as a strategic indicator, the contractor developed a plan to restructure the company.

The plan had four major action components: 

• Immediately address cash flow issues. This included curtailing over head expenses and restructuring all leases that were necessary to continue the company's work.

• Commencement of negotiations with ABC's two major financial part- ners—its bank and surety company.

• Organize and execute a sale to dispose of all unnecessary equipment.

• Critical cost-to-complete valuation of the remaining and in-progress projects.

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• The greatest hurdle involved the negotiation with the surety company. Using an action plan that provided specific milestones and report cards to measure ABC's progress, the contractor negotiated a standstill agreement with the surety. The surety would continue to bond certain predetermined projects on the assumption that the combined capacity of new work and existing backlog did not exceed the maximum amount of bonded work on the books when ABC received notice from the surety. Given the amount of work ABC was putting in place or working off the bonding line, this differ- ence allowed ABC to continue to bid on work that could be profitable.

• The next critical negotiation occurred when ABC met with its bank. Once again, having a very specific plan with measurable milestones helped the plan succeed, and ABC was able to negotiate an overline of approximately $100,000 to get through the toughest phase of the plan.

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• At the same time, ABC negotiated and scheduled a major sale of excess equipment within the first two months of restructuring. This was a real boost for the company: it reduced its monthly outlay by approximately $150,000 without any additional payouts for the recovery of leasing costs.

• By far, the most difficult component to implement was the cost-to-complete analysis of each work in progress. This analysis obviously took a great deal of time and effort on everyone's part. Measuring each cost to complete specifically and accurately (and determining whether there were changed conditions that were not being accounted for) resulted in new information about additional losses that were still forthcoming. This led to further revi- sions of the plan and its cash flow projections—and a second round of discussions with the bank and surety. One thing any contractor in this situation, should always bear in mind is "No surprises for your surety or your banket"

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The Good News

With the assistance of some significant overhead reductions and the extremely successful sale of equipment, ABC was now on track to recovery and a return to a more normal condition. But in its return to normal, there had to be some long-term, institutional changes to the way the company did business. (So, the following systems changes were put into place:

• A permanently functioning cash flow system was established to pro- vide ABC with weekly updates on the "sources and uses" of cash. The cash flow reports encompassed the entire organization (from field la- bor and material costs to overhead expenses, etc.), and they provided a much-needed focus from an internal standpoint. ABC's staff now knew where the money was coming from and where it was going.

• These reports also said volumes about the CEO/owner's proclivity to purchase equipment. Now there was a document where the obvious was stated: if there was no cash, there could be no purchases. It worked. It also provided a great impetus for ABC's owner to get involved in accounts receivable collections because he could then see in black and white what it meant for the accounts receivable to be late.

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• ABC's owner began to subscribe to the philosophy that equipment is only necessary if it can be worked; one should build equity in the com- pany rather than in the equipment. After the turnaround, if ABC needed a piece of equipment for short-term projects, it rented that equipment rather than buying or leasing it.

• The work-in-progress system contained a cost-to-complete component that provided a projection of gross margin. This allowed ABC to re- view on a summary basis every month whether its projects were track- ing with the estimate and, if not, to make changes early on in the field.

• A special emphasis had been placed on controlling change orders with both a written policy and training classes for superintendents and project managers. This additional step went a long way toward helping ABC manage its projects, rather than the other way around.

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Conclusion

ABC is now doing very well. It operates in a controlled environment that focuses on the "business of business" in addition to performing quality contracting projects. This is not to imply that ABC's recovery and restructuring were easy. On the contrary, it was a difficult, time-consuming, painful, and certainly stressful process. But ABC is once again a viable organization because, when change was needed, its CEO/owner said, "Tell me what to do, and I'll do it."

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