While recent years have seen sweeping changes to how projects are performed, subcontractors’ expenses for labor and materials are still being outlaid long before payment is received. The combination of payment delays and uncertain timing creates cash flow and working capital challenges that can limit subcontractors’ growth and create financial strain. Technology has a role to play in solving this problem by helping fundamentally alter the flow of funds in construction payments to address subcontractors’ working capital woes.
Demand for Alternative Lending
Studies from multiple organizations—including the National Federation of Independent Businesses and the National Reserve—report that small and medium-sized enterprises (SMEs) cite lack of access to capital as the main inhibitor to their growth.
That’s hardly a surprise given the forces at work. Banks, hindered by changes in regulation and restricted risk appetite, find financing the typically smaller loans of SMEs less attractive. But while banks’ ability or willingness to lend has diminished, SME demand for working capital hasn’t. In fact, the need for working capital may grow as construction spending continues to rise and construction companies take on additional projects.
This is great news for the industry, but the increase in available projects can magnify working capital issues, especially if subcontractors take on more work than they can support. As the construction industry has learned, the highest default risk occurs during economic recoveries rather than during downturns.
Seeing a void in the market, alternative finance providers—blending finance and technology—have stepped in to fill the gap. Today, technology is fundamentally changing how SMEs access capital. By enabling a data-driven, tech-forward approach, web-based platforms have become central to the rapid growth of alternative finance. These new players have moved the entire loan process online, improving the traditional borrowing experience with a focus on fast decisions, ease of use and transparency.
One form of alternative lending significantly bolstered by technology is supply chain finance (SCF). In simple terms, SCF enables buyers (of goods and services) to maintain or improve their working capital position while enabling their supplier partners to enhance their own working capital and cash flow, typically through early payment. In many cases, a third party provides the earlier payments at a modest cost relative to traditional alternatives. Such programs work by leveraging the financial strength of the buyer to offer the suppliers more favorable financing terms than they could obtain on their own.
SCF programs have been successfully used for years to improve access to working capital in industries such as manufacturing, retail and automotive. Yet, as the market for such alternative approaches continues to grow worldwide, construction companies have largely remained on the sidelines.
A key obstacle to SCF use in construction has been the complex nature of the construction payment process. Rather than a simple exchange of an invoice for payment, traditional construction payments—especially in North America—are complicated transactions with potential risks for all payment stakeholders.
Providing payment to subcontractors traditionally has entailed a lengthy, paper-laden, multiparty process. Invoice payment involves the submission of pay applications, certifications that the billed work has been completed, various approvals, and the collection of documentation related to compliance and liens. Once those steps are completed, a period of time passes before the project owner provides funding for payments, with pay-when-paid/pay-if-paid clauses further complicating the process in some jurisdictions.
Third-party funders and other non-bank entities, which provide the funds for a fast-growing segment of SCF programs, historically have been hesitant to take on the risk of an industry marked by processes that lack both transparency and, until fairly recently, digitization. Because of these factors, as well as the industry’s litigious nature, construction has generally been seen as a high-risk investment for many SCF funders.
But technology platforms that optimize processes and help lessen the risk exposure in payments can change the perception of the construction industry as a high-risk investment.
By transforming opaque, slow-moving invoicing and payment steps into an efficient and transparent process, software tools can help ensure pay applications meet compliance requirements and are “clean” and free of liens. Both are key factors enabling the creation of invoices eligible for accelerated payment through SCF. These tools not only boost transparency into payment processes and facilitate the creation of so-called fundable assets, but they also provide an informational base and audit trail. Payment management software already knows who the buyer and seller are, and such tools maintain a detailed history of their transactions.
Building off of the existing flow of information, tech-enabled SCF programs provide funders with the data and confidence to know that construction invoices are investment worthy.
With construction SCF, third-party funding sources can provide funds to pay subcontractors, enabling significantly accelerated payments. These funders are then repaid when the owner eventually provides funding to the general contractor, closing the payment loop. Subcontractors enjoy the working capital and cash flow benefits of earlier payment, including potentially stronger balance sheets and the ability to expand and grow their business. Meanwhile, general contractors have the potential for stronger relationships with subcontractors, stronger project partners and even lower bids stemming from subcontractors’ reduced financing costs.
Technology already has changed the way construction projects are conceived, planned and executed. Now, that same forward thinking is being applied to how project participants are paid.
Mike Antis is executive vice president of client services for Textura Corporation. For more information, email email@example.com.