How to Build Trust with Sureties and Increase Bonding Capacity by Restructuring Debt: Episode 3

Today, I'm pleased to have Brian Whipple, national surety practice leader at Risk Strategies, here to discuss how you can increase your bonding capacity by restructuring debt and how to build trust with your surety agent.

Brian, when we are looking at trying to help folks increase their bonding capacity from an accounting side, something we have done (I'd like to get your perspective on this in today's marketplace) is restructuring debt on their balance sheet by putting more long-term debt on the balance sheet, and having larger lines of credit, or even having long-term debt pay off lines of credit, so they increase their working capital. Because effectively, as the bonding agent, you're looking at their current assets compared to the current liabilities, and I think depending on the experience, you're giving them 10 to 20 times that working capital as bonding.

So, could you talk about the current market and their acceptance or perspective on restructuring the debt, like we do with more long-term debt availability in the line, and how that impacts the working capital and the ability for you to bond?

Brian Whipple:

Yeah, good question, Don. I think that as a contractor, it's extremely important to look at what a surety company is really worried about. And when we get right down to brass taxes, what a surety wants to know is, if we take on risk via a surety program or an individual surety bond, if the stuff hits the fan, how are you going to finance your way through it?

And that's going to be the first question that any surety company has. How do we solve problems as they arise? And the availability of working capital is the first line of defense; the availability of liquidity. It's the old adage, cash is king. And if an owner decides they're going to have a problem on a job, and they're not going to pay you for a while, or your bank calls a line of credit, for instance, or you have a subcontractor that's not performing and maybe didn't pay for material, and you have to step in and do that, all of those things can potentially lead to surety losses.

And so, what the surety wants to know is, how are you going to deal with those? What liquidity do you have available in the short term to deal with those issues, and how do we represent that on the balance sheet? And so, the restructuring of debt, the making available of more liquidity upfront, over a 90- to 120-day period, is extraordinarily important, and is a really advanced thing for a CPA to be able to do for their clients and is a very valuable thing for them.

Don Hoffman:

So, in reality, I have a contract for $30 million, and I'm having a cash flow problem on the contract, I have to pay my bills or my subs are going to file liens on the job or my vendors, the surety is going to get a lot of comfort to say, "Hey, this company has a $5 million line of credit, and I'm just going to pull money from the line to keep the vendors or subs paid, so they don't file liens on their project that we're building," which is where the comfort comes from.

Brian Whipple:

Exactly right. And the old joke, the old adage within the surety industry is, you're sure the underwriter wants you to have the largest line of credit available, and then they never want you to actually use it. So again, it's like having insurance for a rainy day, right? You want to make sure there's available liquidity if there's a problem. 99% of the time there's no problems, and everybody makes money, and things go well. But that 1% of the time when there is a problem, we must have that fallback plan to know how we're going to finance our way through it.

Don Hoffman:

Working capital, as we talked about, and having lines of credit are very important because that gives them comfort in what their bonding line and capacity is going to be, but then there is the next line of defense, which I believe is the most critical and has to do with trust and confidence and ability, and that is profit fade on contracts.

And when we look at that, when a contractor is saying they're going to make 10% or 20% or 30% on the contract, and it turns out that it came in at a loss, or they said 25% and it comes in at 5%, the bonding company starts looking at these clients and saying, "Wait a minute. We're not sure you know how to estimate your work, or you don't know how to perform your work, or you are going ahead and massaging your financial statements to make us believe you're making money when you're not." Which, no matter which category it falls into of those three, you will lose extreme confidence with the bonding company, and that could either terminate a bonding company's relationship with you, or they would give you minimal amounts of bonds.

And I know this is something you deal with every day, Brian. So, as a firm, we really encourage our clients to be conservative on these projected problems. You don't have that issue, but could you share some of your thoughts? Because I'm sure this is one of the biggest challenges that you're dealing with.

Brian Whipple:

Yeah. Don, you hit the nail on the head. The first key for any contractor to increase their bondability is good internal financial reporting. So, whether that's showing profit fade, or whether it's inaccurate internal balance sheets and income statements, all of those are going to be major red flags to the surety industry.

The surety industry, the surety companies, are always going to base their main underwriting, their annual underwriting, on the CPA statement. They're going to have confidence that CPA statement is correct.

However, throughout the year, many times on a quarterly basis, or certainly a semiannual basis, they're going to be asking for internal financial reporting. And that reporting has to be accurate, or the sureties just simply cannot rely on it, and therefore really get uncomfortable extending further credit. So, to your point, the more conservative that contractors are with their internal reporting, in particular profitability margins, the more successful they're going to be in establishing that long-term trust with their surety.

Don Hoffman:

Yeah, and thank you for that because I think that everybody on the podcast is in the construction industry. They really should be focusing on the aspect that conservatism is critically important, if you want to build up the most confidence and bringing home profitability. Because bonding companies dislike profit fade more than anything else on a client's balance sheet. And also, after lending money to themselves or other people, that's another big no-no. Right, Brian?

Brian Whipple:

Yeah, that's a great point. We always say to contractors, "It's not how much you make, it's how much you keep." So, it really is important for contractors to think two, three, five years ahead at what they're going to need their balance sheet to look like in order to support where they want to go, as opposed to needing a balance sheet that supports what they want to do right now.

I simply point to 2020, and that really strange period of material escalation that every contractor out there remembers well, and balance sheets that were very, very strong in supporting programs for a long period of time looking very similar, all of a sudden needed to be 40%, 50% stronger, because contract sizes increased almost overnight because of material escalation costs.

And so, I always encourage contractors, save within the company as much as you can for a rainy day. Obviously, we want our contractors that are successful to make money. They want to make money. That's the whole point of being in the industry. But you do have to structure that balance sheet long-term to be able to support what it is you want to do long term.

Don Hoffman:

Thank you so much, Brian. Great discussion today. In our next episode, Brian Whipple will be back to discuss trends in the surety business and the economic outlook for bonding, and also offer advice in the event you were involved in a construction claim or a construction dispute on one of your contracts. Thank you.

Transcribed by Rev.com