Prequalifying Subcontractors Important in Today's Economy

Subcontractor failure is one of the biggest risks faced by general contractors (GCs) today. And one of the most effective strategies for minimizing this risk is subcontractor prequalification. This process benefits subs, as well, by providing them with a competitive advantage once they've made the list.

Prequalification isn't new but, in the current economy, it playing a more prominent role in the construction business. Many contractors are even using Web-based collaborative tools to help streamline the process.

Dangerous conditions

As you know, a distressed economy amplifies the risks associated with subcontractor failures. There are several reasons for this:

· Construction work is more difficult to come by, prompting some subcontractors to seek work outside their comfort zones (in terms of skill set, geographic location, financial resources and manpower).

· Most sureties have tightened their underwriting standards and reduced bonding capacity for subs.

· Credit lines and other forms of financing are more difficult to obtain.

· Subcontractor default insurance (SDI) may be less effective in bad times, a GC experiencing multiple subcontractor defaults in a single policy year, for example, can have significant financial exposure, even with SDI.

The best protection is a carefully developed subcontractor prequalification program. Sureties typically prequalify subcontractors for underwriting purposes, but an internal program is important for unbonded subs. Also, SDI providers generally require insured contractors to have a prequalification program in place.

Specific information

The prequalification process usually begins with a subcontractor submission of a prequalification application or questionnaire, together with financial statements and other documents (such as insurance certificates, safety records and licenses). After the GC reviews this information, it may wish to arrange a face-to-face meeting, check the sub references and conduct other background checks.

The specific information required depends on the nature of the GC business and the size and types of projects subcontractors will bid on. Typically, requirements include information about a sub management team, experience and expertise, geographic reach, current and upcoming projects (to demonstrate capacity), past performance history (including any material litigation, claims or bankruptcies), safety record, and insurance coverage.

From a financial perspective, the GC should scrutinize the subcontractor financial statements (or tax returns, if financial statements aren't available) to ensure that the sub has the financial strength and stability to handle the job. The GC should satisfy itself that, among other things, the subcontractor has a healthy amount of cash, a strong current ratio (current assets divided by current liabilities), and accounts receivable that are reasonable in comparison to income. It also important to find out whether financial statements were prepared internally or by a CPA with construction industry experience.

The GC might want to develop a rating system. Whether subs are rated on a point scale or simply on a pass/fail basis, such a system can help speed decisions during the bidding process.

Web-based solutions

There are Web-based prequalification networks that offer significant benefits for GCs and subcontractors alike. From a sub perspective, these networks are a big time-saver because the subcontractor enters its financial and other information only once (with periodic updates). Plus, the networks expose subs to many potential sources of new business within the network.

GCs benefit because the information is automatically routed to all relevant decision-makers, who can review the data and assign ratings. These ratings then become readily available for use in the bidding and award process.

One of the most important benefits of a Web-based network is its ability to automate the updating process. Whether updates are required once a year, every six months, quarterly or at some other interval, the system automatically generates reminder e-mails to the subcontractor. When the sub updates its information, the relevant personnel at the GC are alerted so they can revisit their ratings.

Prequalify, then requalify

Prequalification should be an ongoing process, not a one-time event. Even financially strong subcontractors are susceptible to the risks and uncertainties of the construction industry.

It critical for GCs to monitor subcontractor performance and require prequalified subs to requalify periodically. (See the sidebar Subcontractor red flags could signal trouble.) This process benefits subcontractors as well, because prequalification and requalification forces them to regularly take their own financial pulse.