The construction business is risky business — especially in today’s inflationary and supply-chain-addled environment. That’s why it’s critical for general contractors to take steps to mitigate their risks, which includes minimizing the likelihood of subcontractor default by ensuring that the subcontractors they work with can satisfactorily complete work.

Assuming you’re a general contractor, failure to thoroughly vet subcontractors can result in delays, budget overruns and substandard work quality — all of which can diminish profits and damage your reputation. Among the most effective ways to reduce subcontractor risk is to implement a prequalification process.

3 areas to examine

When evaluating subcontractors, the type of information you gather and the depth of the analysis you perform will depend on the nature of your business and the size and complexity of your jobs. But here are three common areas to examine:

1. Capacity. Look at the size, skills, experience and geographical reach of the sub’s workforce. Review the types of projects and volume of work the company has handled in the past, as well as its current jobs and backlog. Inquire about its equipment holdings and ability to lease assets it would need for your jobs. Ask for references from other general contractors, customers, lenders, sureties and suppliers. If possible, visit one or two of the subcontractor’s jobsites to inspect work quality.

2. Financial stability. Invite subcontractors who are interested in completing your prequalification process to submit their most recent financial statements for review. Then calculate key financial statement ratios — such as the current ratio (current assets/current liabilities), return on equity and working capital turnover — to get a handle on the company’s financial strength. Make sure its accounts receivable and cash flow is healthy, and that owners maintain sufficient equity in the business.

3. Reputation and performance history. Look into the background and reputation of the company, as well as its owners and management team. Have they ever been terminated from or walked off a job? Have they ever filed for bankruptcy? Do they have a history of litigation? Evaluate the subcontractor’s safety plans, practices and history. What is its workers’ comp experience modification rating? Does it have a history of OSHA violations?

Policies and procedures

To ensure a thorough, reliable prequalification process, set formal policies and procedures. For example, create forms, questionnaires or checklists — either on paper or online — to gather relevant documents and information from prospective subcontractors. Prequalification software may be available to automate the process.

Alternatively, you could outsource the prequalification process. Some sureties will prequalify subcontractors on your behalf. An advantage to this approach is that subcontractors may be more comfortable sharing financial statements and other sensitive information with a bonding firm than with your construction company.

To encourage subcontractors to cooperate, some general contractors offer financial incentives to subcontractors who meet prequalification standards, such as accelerated payment terms.

It helps subcontractors, too

Prequalification offers significant benefits to subcontractors, too. Winning a spot on a general contractor’s preferred list can provide a competitive advantage. In addition, working with general contractors that prequalify subcontractors provides some assurance that other subcontractors on the project will be qualified, reducing the risks of delays and defaults. Indeed, it’s a process that can be a win-win for everyone.

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