The construction business is risky business – with inflation, supply-chain complexities and the skilled labor shortage all combining to make life interesting to say the least.

If you’re a general contractor, among the biggest risks you face is subcontractor default. The failure of a subcontractor to fulfill its obligations can result in delays, substandard work quality and cost overruns. In turn, your company’s profitability and reputation may take a hit.

Perhaps the most effective way to guard against this risk is to implement a formal prequalification process.

3 areas to examine

When evaluating subcontractors, the type of information you gather and the depth of the analysis you perform will depend on the nature of your business and the size and complexity of your jobs. But here are three common areas to examine:

1. Capacity. Look at the size, skills, experience and geographical reach of the subcontractor’s workforce. Review the types of projects and volume of work the company has handled in the past, as well as its current jobs and backlog. Inquire about its equipment holdings and ability to lease the assets it would need for your jobs. Ask for references from other general contractors, customers, lenders, sureties and suppliers. If possible, visit one or two of the subcontractor’s jobsites to inspect work quality.

2. Financial stability. Invite subcontractors who are interested in completing your prequalification process to submit their most recent financial statements for review. Then calculate key financial statement ratios — such as current ratio (current assets / current liabilities), return on equity and working capital turnover — to get a handle on the company’s financial strength. Make sure its accounts receivable and cash flow are healthy, and that owners maintain sufficient equity in the business.

3. Reputation and performance history. Look into the background and reputation of the company, as well as its owners and management team. Has it ever been terminated from or walked off a job? Has it ever filed for bankruptcy? Does it have a history of litigation? Evaluate the subcontractor’s safety plans, practices and history. What is its workers’ compensation experience modification rating? Does it have a history of OSHA violations?

Policies and procedures

To ensure a thorough, reliable prequalification process, set formal policies and procedures. For example, create forms, questionnaires or checklists — either on paper or online — to gather relevant documents and information from prospective subcontractors. Prequalification software may be available to automate the process.

Alternatively, you could outsource prequalification. Some sureties will prequalify subcontractors on your behalf. A potential advantage to this approach is that subcontractors may be more comfortable sharing financial statements and other sensitive information with a bonding provider than your construction company.

To encourage subcontractors to cooperate, some general contractors offer financial incentives — such as accelerated payment terms — to businesses that meet prequalification standards.

It helps them, too

Prequalification benefits subcontractors, too. Winning a spot on a general contractor’s preferred list can provide a competitive advantage. In addition, working with general contractors that prequalify subcontractors provides some assurance that other subcontractors on the project will also be trustworthy, reducing the risks of delays and defaults. We’d be happy to help you analyze and choose the right financial metrics for your prequalification process.

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