The Ultimate Guide to Understanding Construction Payment Management
Why are construction payments so unique? The truth is that there is more uniqueness driven by tradition and habit than by necessity. Construction payments are fundamentally similar to many other industries in the mode of progress payment and the need for validation and compliance documents that accompany them. With that in mind, the process and forms that have become the norm work, just not efficiently and often not well either.
AIA G702 and G703
By far the most common form for applying for construction payments is the AIA G702 and G703. Trademarked in 1992, the AIA Document G702, Application and Certificate for Payment, and G703, Continuation Sheet, provide forms on which the contractor can apply for payment and the architect can certify that payment is due.
In it’s foundation, the G703 lays out a detailed list of items with their respective contractual values, more commonly known as the schedule of values and allows the applying payee to update for progress on a periodic basis. The G702 is a summary of the G703 that incorporates information regarding previous payments and defines the total amount due for the period being invoices.
The AIA templates were originally designed to allow a general contractor to update progress and submit for review by the developer or developer representative that would review progress and approve and submit to the mortgaging bank to process their draw, which is a fancy way of saying release the next tranche of funds to the project. Today, the overwhelming number of AIA G702 and G703 forms exchanging hands are not between GCs and developers, but between GCs and their subcontractors driven by the fact that you normally have 10x+ subcontractors for every one general contractor. Moreover, the GC’s role is more one of a consolidator, validating that the subcontractor progress is accurately represented and translating that to include amounts due for their work and value add and finally for owner and bank submission.
To add to the pain, AIA documents today are predominantly being managed as excel spreadsheets that get updated, saved and emailed between subcontractors, with varying degrees of computer literacy and GCs. Couple that with the fact that you can easily have 10+ items in each subcontractor schedule of values and you have an environment that requires a GC to request, receive, review and approve updates on hundreds of items every month. The subjective nature of the progress being reported, mainly in percentage terms, results in frequent rejections and resubmissions, again via excel spreadsheet and email. You don’t need to be a mathematician to realize that you very quickly have multiple dozen spreadsheets, containing hundreds of items that exchange hands and get consolidated in an effort to get to a very accurate dollars and cents number that will be drawn from the bank.
If you have ever consolidated spreadsheets, you are likely reading on in horror at this point. Version control becomes a fundamental risk, as it very quickly becomes challenging to align on the final version that was agreed on in that draw period and the risk of including the incorrect version is prominent and frequent. Furthermore, the process of updating these spreadsheets is manual and the formulas embedded are easily editable, oftentimes some of the values within the document could be miscalculated or misrepresented due to an error in data input or even a faulty formula. In case my point is not blatantly clear, progress invoicing in excel is extremely prone to errors and misrepresentations.
With all that said, the AIA invoice and method is a great way of driving detail and transparency in the invoicing and payment process and has much merit. As I alluded earlier in this document, it works, just not always well and never efficiently. Thankfully there are tools in the marketplace that have started to address this issue for example, in a shameless plug, our Theo Build tool. The goal of these tools is not, and should not be to recreate and reimagine the output, I think we would all agree that the output, mainly an itemized representation of the construction project with detailed progress by period, provides the required details to get the job done. By addressing some of the main shortfalls of performing this process via excel and email, we can drastically improve the efficiency and effectiveness of the process while making it more compliant, less risky and significantly cheaper. What is more, not only will organizations save time by reducing the effort of the finance or admin team directly in charge of this process, but of the project managers and field teams that are working to approve progress allowing them to focus on more value add activities like ensuring schedules and quality standards are being met.
Progress Updates
A second key point to discuss is the process and method of updating progress in pay applications. It does not matter if you are using AIA templates or simple verse invoices, it can often be challenging to define and agree as to what is owed in the very objective terms required i.e. dollars and cents. Subcontractors and contractors will always want to get paid as much as possible, as quickly as possible where the exact opposite is normally the case with the developer and bank on the other side. This creates a general tug of war of sorts where contractors err on the side of over estimating completion and developers push back in the opposite direction before finally arriving at a number.
Payment applications are frequently requested and created in advance of the stated completion date for that progress. In other words, given the lag created by the administrative process that goes into payments first by the GC and then by the developer and bank, GCs often request progress updates as early as the 10th (possibly sooner) of each month for progress expected to be completed by the end of the billing period, normally the end of that month. This forces GCs and subcontractors to talk about progress not in terms of what is complete, but in terms of what will be completed by month's end, a mark which is frequently missed. Furthermore, it is often more practical to talk about progress as a percentage completion rather than a tangible completion milestone. How can you define partial completion of an electrician, for example? By the lineal foot of cable laid, by the installed equipment put in place, by the stage of completion, by segments in the construction, etc. The point I am making here is that oftentimes, unless very explicitly defined in contracts which would be excessive and impractical, one person’s 50% could very easily be a very different number in the eyes of someone else. Coming to an agreement is subjective and a fundamental friction point in the whole process.
Finally, none of this takes into account the contractual terms that have been agreed upon for payment that are often not aligned with the actual progress as is with a value loaded schedule or even payment terms with subs that might include a deposit and predefined payments depending on completion of certain milestones. As the owner of a millwork business, my default bid required 50% upfront, 25% upon completion of fabrication and prior to shipping and 25% after installation. To state the obvious, this very frequently did not match the actual project completion that is sought from progress payments and would require a level of normalization by the general contractor to keep the developer and bank aligned and the funds flowing.
Compliance Documents
In addition to the core invoice document (AIA or otherwise), there are multiple other documents that need to be tracked in order to process and minimize the risk associated with the invoicing and payment processes.
For starters let's discuss the Certificate of Insurance and the W9, everyone in the supply chain has an inherent interest in ensuring the completeness and adequacy of these two documents that should be gathered in advance of any payment being made. As is common, once payments have been made, the incentive of the payee to comply with compliance requirements is basically willful and leave the GC and the Developers exposed so unnecessary risk. Furthermore, ensuring the validity of these documents is an ongoing process, particularly with the certificate of insurance where coverage levels might decrease or even expire during the project requiring a refresh in order to ensure compliance. In my experience, the vast majority of general contractors don’t proactively review certificates of insurance and often request an updated copy months after the expiration date. In the event of an accident, those periods could potentially result in the GC or the developer being held liable for damages that should have been covered by someone else.
The first worker’s compensation claim that I was forced to file involved an installer that we had hired to support for a few days at a job site. Within the first couple hours of working, he misstepped on a ladder and fell and landed on his elbow. The fall was short, he was not even two feet above the concrete, yet his fracture resulted in a trip to the emergency room, his inability to work for over two months and multiple subsequent visits to specialists including physical therapists. Between lost wages and medical bills, the otherwise minimal accident resulted in a claim that approached $100,000, thank god for The Hartford! Had it not been for our workers compensation insurance, that would have been initially our responsibility. In the event we were unable to cover the expense, the GC would have been responsible and in the event the GC’s inability or lack of insurance coverage, the burden would have ultimately fallen on the property owner. This was all for a two foot fall, imagine if, god forbid, someone died, all moral and emotional impacts aside, this could become a claim in the millions of dollars exposing GCs and owners to very real financial risk.
Secondly, and likely the most unique to construction compliance document is the lien waiver. For those not familiar with lien waivers and the concept of mechanics liens in general, here is the 1000 foot overview.
Mechanics liens rights are given to builders, be it trades people or general contractors as a protection against default in payment. Much like any other type of lien that gets filled against the real property, mechanics liens are registered with the local jurisdiction as a claim against that property. If you think about it in practical terms, a plumber cannot go back to a house and dig up their plumbing if the owner of the property fails to pay once the work is complete. This is an exceptionally powerful right given to builders that helps them collect payment. Mechanics lien laws vary from state to state and even from county to county, but the fundamentals are largely the same. In most cases, the lien rights are granted all the way down to the second tier subcontractors, so the contractors hired by your subcontractors e.g. your plumber hires a company to take care of the concrete work required for them to complete their work and pays them directly, the concrete contractor would be hired and hence have a contract with a contractor that was hired by the general contractor that was hired by the developer/owner. This is relevant, because it illustrates all the parties that could potentially file a lien on a property and have claim against its title. The property owner, being potentially up to 4 levels removed from the second tier contractor could ultimately end up liable for this bill in order to clean up the title to their property. Furthermore, mortgaging banks that hold the primary lien on a property have a significant interest in title remaining clean and will often not accept real property collateral if the title contains any other liens, hence they will potentially stop funding a project in case of a lien, even if the lien is insignificant in terms of value against the property.
As such, there are three typical types of lien waivers that could be required for each project.
Conditional lien waivers are submitted at the time of an invoice submission and essentially state that if they get paid the amount in the pay application (also stated in the lien waiver) the contractor waives their right to file a lien for that amount due. Conditional lien waivers are then effective for a property owner to remove a lien if they are accompanied by proof of payment like a cancelled check.
Unconditional lien waivers normally collected after each payment and state that a certain amount has been paid and the respective pay application has been satisfied so the contractor waives their right to file a lien for that amount due.
Lastly the final and unconditional lien waiver is requested at the end of the project, normally accompanied by the payment for retainage. The final and unconditional lien waiver essentially states that all payments have been satisfied for the labor and materials in the project and the contractor has no additional claims on the property from the work performed in that particular project.
Though the fundamentals of lien waivers are fairly consistent the detailed requirements may vary slightly from contractor to contractor and project to project mainly driven by legal language required by local law and often dictated by banks or developers. Some projects require all three waivers, some only require only the unconditional and sometimes just the final. Some projects require notarized original signatures and others are satisfied with a signature or even an eSignature. Whatever the permutation might be, getting lien waivers correct is of utmost importance.
The last item I would like to discuss as it pertains to lien waivers is the sworn statement. This is a document that is often required by contractors, and sometimes subcontractors, that outlines everyone that was a party to the project within their contract, e.g. sub tier contractors, material providers etc. As alluded to above, a subcontractor’s contractor often retains the right to file a mechanics lien in the event of non payment. And, again as discussed above, that lien would go on the real property meaning that the owner could end up paying these bills to maintain their title clean. The sworn statement is thus used by owners to ensure that they have a proper list of everyone that could potentially file a lien against their property in order to ensure that an accurate and complete set of lien waivers is received, mitigating their risk of a lien.
Errors or inconsistencies, however menial, can often result in rejected pay applications which in turn can often delay payments for the entire project. Because most general contractors follow, or try to follow, a paid when paid practice (see below), an error or a missing lien waiver for a small subcontractor can imply the withholding of the entire project draw and result in delayed payments for everyone. In turn, errors that go unnoticed can potentially lead to owners taking unnecessary, and unwarranted risk that could prove costly.
All of this turns a somewhat mundane task of collecting what amounts to a glorified signed receipt into a challenging logistical exercise that is required to be orchestrated on each monthly draw. Given the uniqueness in this process to construction, many contractors continue to manage lien waivers manually and track them in spreadsheets. As is thematic in construction payments, spreadsheets are effective yet reactive and inefficient. Furthermore, spreadsheet trackers do not ensure the accuracy of submitted lien waivers. Tools that allow automation, both on the creation of the lien waiver, the signature and the tracking of completion are extremely helpful in lien waiver management. Companies often rely on eSignature platforms that can be extremely expensive, often $5+ per document and are not truly integrated into the invoicing process. We took a more holistic approach to lien waivers in our Theo Build tool and made it an native step in the invoicing process that allows subcontractors to fully complete and execute a lien waiver document systematically at the time of creating a pay application removing the burden from the subcontractor, but also ensuring they get done properly.
Once the project has been completed and prior to releasing the final retainage payment, contractors often collect what is known as the close out documents. These vary widely from project to project but very commonly include a final lien waiver, a sworn statement and a limited warranty, all documents that are normally required in the owner contract and thus normally feed into the subcontract.
Retainage
In order to ensure financial coverage, owners often retain a percentage of every payment that gets paid to the contractors and subcontractors until the very end of the project when everything has been satisfactorily completed. This is called retainage. Though retainage varies from contract to contract, the most common that I have seen has been 10%. This in turn means that only 90% of every payment request submitted will be paid. This also means that subcontractors that perform their work at the beginning of a project could potentially be waiting on the last 10% of their payment for months or even years in some cases. In some trades, the retainage could signify the entire profit margin of a project and could be significantly delayed by no fault of the contractor.
Though this is often not a very flexible clause in a contract, it is important to understand the effects that this can have on a company's cash flow and hence, open conversation at the time of negotiating a contract can be very beneficial in the long run. For example, I was successful in a few occasions when I showed that, based on the projet schedule, we would be 100% complete with our work months before the project was set to be completed and that withholding our retainage would essentially mean that we would not see our final payment for many months after our work was completed. Instead, what the contractor and owner agreed was that we would agree to a 10% retainage as was consistent with the other subcontractors, but that once our work was completed the general contractor and/or the owner representative had 30 days to highlight any issues at which time, our final payment would be due. Then there were other times where we simply had to wait.
Whatever the final agreement was, if I can provide one lesson learned is the need for detailed documentation and sign off of the work at the time of your own completion. We were providing finished carpentry and what happened to us on multiple occasions was that our furniture would get damaged by being in an active construction site for many months after it was completed. Once the owner finally performed a final walk through inspection, all this damage would be highlighted, and the lack of proper CYA often resulted in challenging discussions with the general contractor and owner, and more times than not, required us to travel back to the project site and make costly repairs that were not ours to begin with. With that in mind, we became very proactive about advising general contractors to protect our furniture as soon as it was installed with ram board and other such materials and made it a point to take as many pictures and sign offs as possible.
Retainage is often where all the disputes in payments happen. It is important to be proactive, transparent and to over communicate to minimize surprises and ensure that final payments will be performed in their entirety.
Paid when Paid
The concept of paid when paid can be fairly counter intuitive at first and has big implications to a subcontractor’s recourse in the event of non payment. Paid when paid is a common clause in general contractor contracts with their subcontractors that stipulates that the general contractor will pay the subcontractors within a predefined period of receiving payment from the developer. This means that if a GC does not get paid for work performed, they do not have a contractual obligation to pay the subcontractor for the work. It also means that payment terms that are typical with most vendor contracts can be futile in construction because timing on payment often depends on the GC getting paid and delays are frequent and completely out of the subcontractors control.
The legality and enforceability of paid when paid clauses varies from state to state, some states like California simply do not allow them and others make it a timing clause whereas, even if the GC does not get paid, they are still contractually obligated to pay the subcontractor in a reasonable time frame. As such, I would advise contractors to consult their attorneys before agreeing to this clause if they are not clear as to the potential implications.
Finally, regardless of the paid when paid terms and enforceability, these are independent of a contractor's mechanic lien rights which are the ultimate collateral for non payment. As I had a general contractor tell me the first time I was fighting a paid when paid clause, if we don’t get paid we will be marching side by side to the county office to file our liens which felt like fool’s comfort at the time but in reality is technically and practically accurate.
In addition to the basic timing of payments, subcontractor contracts often make reference to the owner contracts for multiple clauses and requirements, for example acceptance criteria. Subcontractor are thus entitled and should request the language that is being referenced and that they are thus agreeing to. Again, speak to an attorney if you need clarification. Payment and work acceptance are the most frequent sources of disputes and contractors are best served ensuring clarity and alignment with all their trade partners.
Payment Management tools and enablers
In the context of this document, payment management encompases the entire life cycle of the construction payment, from the progress reporting by the sub, to the consolidation of the GC to request payment from the developer through the submission to the primary bank that will approve the funds and distribute them back down the chain.
The complexity of this process varies from project to project and between sub industries (residential, commercial and industrial). For examples residential work can be simpler when working directly with a home owner and shorter cycle subcontracts that can be paid in one payment whereas large infrastructure projects are often loaded with complex compliance requirements mandated by the governmental agency paying for the project. Whatever the requirements may be, there is a need to track pay applications, compliance documents and payments in order to continue moving the project forward while not taking on any unnecessary risk.
Tools with different levels of sophistication and connectivity help general contractors, developers and banks work through this process effectively. By far the most widely used is a simple spreadsheet that starts with a project budget and tracks each component of the process that is being received via email or even physical mail. As a finance nerd, I am a huge proponent of spreadsheets for many uses as it can be a very effective tool that is easy to configure and implement, however they are not effective for this use case. Spreadsheets are not great collaboration tools, they do not store documents and automation is limited meaning that most of the input will be manual and prone to errors.
I think about payment management tools in three main dimensions and core requirements:
- Single source of truth. In other words, having a single information source that everyone works off of. This was my biggest challenge with the current process of excel, pdf and email. Version control was a fundamental challenge and we frequently agreed to a pay app that was different to the one that the GC had agreed to. Finding documents for reference or dispute was messy and time consuming as you frequently had many versions of a pay app with their lien waivers without real clarity as to which one was the final one.
- Automation and proactive data validation. A quote, a budget, a pay app, a lien waiver and a payment (check, ach, etc.) are often independent documents that are not linked yet contain much of the same information. Variances between these documents happen frequently and are a common source of disputes and misalignments amongst stakeholders.This forces companies in multiple levels to spend valuable time reconciling and understanding where discrepancies occurred and what needs to be corrected. According to a recent benchmark study from Pricewaterhousecoopers, 30-40% of finance efforts can be reduced by automation and behavioral change. Interconnected tools that allow a GCs, Subcontractors and developers to ensure consistency from bid to payment with tracked modifications.
- Compliance and document management. Last but not least, I found that tracking and managing compliance documents was a tremendous challenge and one that forced me to be very reactive. At any moment of dispute or misalignment, I found myself going through emails and text messages to be able to validate and document my point. Having a proactive approach to managing documents saves companies time and effort, but more importantly ensures that the right documents are available at the right time. This prevents them from taking on additional expenses from the document gathering process and more importantly can prevent them ending up on the losing end of a legal dispute.
Tool evaluation should be first and foremost a function of finding a tool that has the right features that will allow your process to improve and make your employees' lives easier. A secondary yet probably the most important factor should be the sizing of a tool. The issue that companies often run into is that they take tools that are too big and complicated to give them value. Like taking on a project that is too big, companies often struggle with the end to end tool implementation which goes well beyond setting up a tool and into the actual behavioral changes of their team that will allow them to get the full benefit. I have hd numerous conversation with companies that implemented market leading tools only to find out that unless they got every stakeholder onboard and adequate using the tool, they struggled to improve any single process, something that is less of a challenge for larger companies that have the appropriate IT infrastructure and implementation budget to go through the right change management protocols. Furthermore, by far the biggest challenge I have heard of has been getting subcontractors to play ball. Oftentimes, despite even contractual agreements to do so, subcontractors refuse to spend time using new tools. In practicality, this requires them to learn a new tool and process potentially for single use and often to achieve a process that they already do successfully, be it in a more manual way. The impact of the entire supply chain ecosystem should be top of mind to ensure robust adoption and long term success.
Finally, I am a big proponent of the 80/20 rule on both features and adoption. For features, think about process modifications in terms of ‘why not?’and you current processes in terms of ‘why?’. Most software developers go through robust market assessments and process design protocols and strive to base their tool on bet in class processes and practices. From my experience with system implementations, even fortune 500 companies often find that there is no hard requirement to keep a process instead of modifying it to fit the tool, let’s face it, we all receive subcontractor invoices and pay bills, the rest of it is more times than not a product of how our team has organized themselves. In terms of adoption, find a tool that will allow you to automate and improve on the majority and deal with the exceptions, particularly when it comes to subcontractors. Remember you hired them because the value that they bring to your construction project through quality work at good prices, so finding a way to work with them is imperative to your long term success.
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