Retainage has long been a contentious practice in the construction industry. Unfortunately, it appears unlikely to disappear anytime soon. The good news is that by recognizing and planning for the negative impacts of retainage, you can reduce the risk to your business’s financial performance.

Owner’s benefit

In a typical retainage scenario, the project owner withholds a certain percentage of earned revenue (typically 5% to 10%) until completion or the achievement of certain milestones. Theoretically, doing so helps reduce the risk that the general contractor won’t complete the job according to the construction agreement. It effectively shifts the negative financial impact of disputes, delays, mistakes or outright failure from the owner to the contractor.

In the eyes of owners, retainage also incentivizes construction companies to perform at a high level. And it creates some breathing room to pursue dispute resolution or litigation when necessary.

Multiple downsides

From a general contractor’s perspective, retainage could offer a potential upside: It can sometimes eliminate the requirement to obtain a performance bond, letter of credit or similar financial guarantee. However, the downsides usually far outweigh this perk.

Perhaps the most obvious adverse impact relates to cash flow. Retainage makes it harder to cover the costs of materials and labor, as well as manage other expenses necessary to keep a project on schedule. As a result, most construction businesses must either have substantial cash on hand or the ability to secure financing. (See “Protect your company with a retainage reserve” below.)

The strain can be particularly difficult for contractors working on large projects or multiple jobs simultaneously. And it’s often exacerbated when owners delay release of retainage, which typically occurs because of an oversight, dispute or slow accounts payable practices.

Retainage also creates administrative headaches and complicates accounting. It requires careful tracking of project progress so the contractor can determine and support when retainage should be released. In addition, contractors need systems in place to promptly notify owners of upcoming retainage release obligations — and formally follow up if funds remain withheld.

4 risk management measures

As mentioned, your hands aren’t completely tied when dealing with retainage. Here are four risk management measures to consider:

1. Replace retainage with retention bonds.

In some cases, rather than having a percentage of payment(s) withheld by the owner, you can buy a bond and name the owner as the beneficiary. The owner receives comparable protection with fewer administrative burdens, while you receive full payments. This assumes, of course, that the bond premium is less than the owner’s desired retainage amount and your construction company financially qualifies for the bond.

2. Refine contract language.

Don’t cut corners when drafting contracts or rely on outdated agreements. Many disputes arise from disagreements about scope or performance standards. Use clear, unambiguous language when defining retainage terms — especially “substantial completion” — and conditions for release.

You also might want to restrict how retainage funds may be used. For example, can they compensate the owner for workmanship defects? If your company has a strong track record of delivering high-quality work, you might be able to leverage it to negotiate more favorable terms, such as the release of retainage at key milestones rather than on completion.

3. Document, document, document.

Keep detailed records of job progress, payments received and communications regarding retainage. Documenting owners’ acknowledgments of satisfaction with your work can be particularly valuable. Additionally, closely track change orders and any other occurrences beyond your control that trigger delays.

4. Wield relevant laws to your advantage.

Make sure that you, your leadership team and all your project managers are well-versed in applicable state and local retainage laws. Depending on the jurisdiction, governing bodies might impose retainage caps, escrow requirements and release timelines. Also investigate the interplay between retainage and mechanics’ lien laws.

Great help

Wrangling with retainage isn’t easy. However, it’s far better to recognize the risks and develop coherent strategies for managing them than to look the other way. Your professional advisors can be of great help. For instance, work with your attorney to fine-tune contracts and fully understand your legal rights. Meanwhile, ask your CPA for assistance with job costing and ascertaining the true financial impact of retainage.

Protect your company with a retainage reserve

Financially sound construction businesses often rely on cash reserves to protect against emergencies, unpredictable economic conditions and the industry’s cash flow challenges. If your company regularly encounters the negative consequences of retainage (see main article), consider establishing a dedicated retainage reserve. It can provide financial relief when retainage payments are delayed or tied up in a prolonged dispute.

To get started, open a bank account specifically for a retainage reserve. High-yield business checking accounts often work well because the accumulated funds will earn at least some interest. But shop around and see what works best.

Next, sweep a defined percentage of revenue from each project into the account. If you already have a general cash reserve, consider transferring some of those funds into the retainage reserve to raise its balance more quickly. Set a goal for the desired reserve amount, so you’re not diverting funds indefinitely. Maintain the account carefully, replenishing it as necessary and safeguarding against fraud.

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