The latest edition of Surety Corner introduced the topic of bond limits, which could hinder an entrepreneur’s growth and general areas of interest to ensure you are maximizing your bond limits.
The example we used was contractor XYZ who had working capital of $ 500,000, which resulted in an overall bonded labor program of $ 10 million based on leverage 20 times higher. However, XYZ is looking to take on bigger work and to get this project into its backlog it needs to increase the overall limit to $ 12 million.
As a reminder, working capital is cash plus receivables minus current debts (supplier debts, wages payable, taxes, current portion of debts, etc.).
So based on the scenario above, what options does entrepreneur XYZ have to increase working capital and ensure he has adequate limits?
Use capital to increase your surety capacity
The most common, easiest, and fastest approach to increasing working capital is a solution known as a capital injection. In the scenario described above and using leverage 20 times more than working capital, entrepreneur XYZ needs working capital of at least $ 600,000 to reach a total of $ 12 million . With a current working capital of $ 500,000, XYZ will need to add an additional $ 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 then subordinate that amount to the surety company.
Subordination is a formal arrangement that allows the loan to be treated as equity and working capital with the entrepreneur agreeing to leave these funds in the business to support the business. These funds can be used by XYZ to pay business expenses (trade debts, salaries, etc.).
What if the owners of XYZ don’t have the money available to inject into the business?
If the owners of XYZ don’t have the cash or prefer not to lend that money to the business, then we’ll have to look for ways to organically increase working capital. XYZ has borrowed $ 100,000 from its operating line of credit, which has a negative impact on its working capital.
In order to increase working capital, entrepreneur XYZ chooses to approach his operating lender and asks him to consider âcancelingâ this debt. This means that instead of the debt being viewed as current debt and repayable on demand, the bank agrees to structure this debt as a term loan repaid over several years.
In this case, the bank agrees to let XYZ pay off the $ 100,000 debt over five years, so the current portion owed 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 brings them to the required $ 600,000.
Restitution of receivables and updating of your bond company
Another area that could reduce your working capital is debt. Many surety companies will review receivables older than 90 days and discount them from working capital as they believe that these amounts will be collected in doubt. Making sure you keep track of old debts and identifying with the surety company what items are being withheld (withholding is included in current assets and therefore in working capital) will ensure you get the most credit you have. you deserve.
XYZ has $ 500,000 in receivables, but $ 100,000 of these are over 90 days old, so the bond company discounted this amount of XYZ’s working capital. Once the investigation is complete, it turns out that $ 50,000 of this amount was collected last week and the remaining $ 50,000 is a holdback payable in three weeks. With this good news, the bond company credits the $ 100,000 to XYZ’s working capital.
Use capacity to increase your link limits
Ultimately, most surety companies are financial entities at heart. The majority of people working in surety companies are accountants or financial experts by trade, and most have no formal training in construction. Accordingly, the ability of an entrepreneur and his broker to clearly explain the operations of the entrepreneur is essential to increase the limits and secure this extended work. Doing this effectively can sometimes allow an entrepreneur to increase surety capacity without immediately increasing capital.
A good example of this is the structure of the contract. Many contractors will sign fixed price construction contracts like CCDC 2. However, many also use different contract structures like construction management like CCDC 5B. The risk difference between a fixed price 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 subcontract default or litigation is transferred to the owner. Clearly explaining this risk and how safe an entrepreneur’s backlog is can provide additional leverage.
Part 3 of our Is Your Bond Company Slowing Your Growth series will look at additional tips and tools that can be used to ensure that your bond company is not limiting your potential.
Jamie Collum is the Vice President of Construction for FCA Insurance. He has given 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 for a large national surety company, Cartwright uses his expertise to help FCA clients manage and strengthen their surety capacity.
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