Executive Summary

Every subcontractor brings risk to your projects, whether it’s the risk of default, safety incidents, poor quality work, or environmental mishaps. Prequalification is a critical process for understanding and mitigating these risks.

Traditionally, surety bonding companies underwrote subcontractor default risk. With the popularity of subcontractor default insurance (SDI), through which GCs take on more risk—and potentially the reward of more profit—preconstruction teams have emerged as de facto underwriters. A similar trend has played out in property and casualty, as contractor-controlled insurance programs (CCIPs) have shifted risk (and reward) to GCs, requiring more advanced safety strategies.

This document provides a comprehensive guide to subcontractor prequalification. By implementing the strategies and tools outlined in this guide, GCs can enhance project outcomes, foster stronger subcontractor relationships, and build a culture of continuous improvement that benefits owners, GCs, and subcontractors.

Importantly, prequalification should not produce binary, pass/fail decisions. The result should not be either “Yes. We can use this subcontractor” or “No. This subcontractor is too risky.” Instead, GCs should use prequalification as the starting point for a collaborative approach to mitigating risk.

We call this “Contractor Success.”

This may seem daunting to a GC without an established prequalification process or a formal process for managing subcontractor relationships. It shouldn’t be. The journey to effective prequalification and contractor success can consist of small steps toward a bold vision.

Why Subcontractors Default

Defaults arise from a combination of financial, operational, and external challenges, but often in the context of the subcontractor overextending themselves in pursuit of more business. As one leading SDI underwriter aptly noted, "Subcontractors don’t die of starvation; they die of overeating." Typical reasons for default include:

The "Three Cs" of Underwriting

Traditionally, surety bond underwriters have used three fundamental criteria – Character, Capacity, and Capital – to assess the risk of subcontractor default. These principles can be effectively applied to a GC’s prequalification process.

Assessing Character

Below are the steps and considerations for assessing the character of a subcontractor:

1. Confirm Corporate Standing. Verify the corporate entity's good standing by reviewing its formation documents (e.g., articles of incorporation) and requesting a certificate of good standing from its state of incorporation. Understand whether it has a parent company or recently changed its name, as this may change the risk profile.
2. Review Officers and Directors. Gather a list of the subcontractor's officers and directors and investigate whether they own related companies or have been involved in problematic entities. This ensures they are not using "shell game" tactics to obscure risks.
3. Inquire About Past Defaults. Ask directly about any past defaults on projects. A pattern of defaults can signal significant operational or financial issues. Require the subcontractor to attest to fully and truthfully answering these questions.
4. Investigate Litigation History. Request details of past and current litigation involving the subcontractor. Ongoing lawsuits can indicate unresolved disputes that may affect project performance. Verify using third-party legal databases.
5. Verify Licenses and Certifications. Ensure the subcontractor holds all required licenses and certifications to perform their scope of work. Ensure they are specific to the project location and not expired.
6. Confirm Good Standing with Unions. If the subcontractor uses union labor, require a letter of good standing from each union. Failure to pay union dues is a leading indicator of financial instability.
7. Master Subcontractor Agreement. It’s important to have easy access to these documents during prequalification to confirm they are fully executed and understand the terms of the relationship.
8. Disadvantaged Business Certificates. If the subcontractor is a disadvantaged business entity, such as a small business, woman-owned business, minority-owned business, etc., gather certificates to validate their status.

Assessing Capacity

Assessing a subcontractor's capacity is essential to ensuring they can meet a project's demands without overextending their resources. This involves evaluating their labor force, industry expertise, geographic experience, and operational capabilities.

1. Confirm Corporate Standing. Confirm that the subcontractor has successfully completed projects of similar size and scope. This ensures they can manage the complexities and resource demands of your projects.
2. Review Officers and Directors. Assess the subcontractor's experience in your project’s industry. Ensure the assigned project manager and team have the required expertise, as these learnings reside at the team or individual level.
3. Inquire About Past Defaults. Verify the subcontractor’s familiarity with local building codes and regulations. Request a list of completed projects in the region and evaluate their ability to leverage local relationships and regulations.
4. Investigate Litigation History. Conduct workforce assessments by requesting staffing plans, historical workforce data, and manpower schedules. Compare their manpower trends against their backlog to identify signs of overextension.

By thoroughly examining these areas, prequalification personnel can gain a clear picture of a subcontractor’s ability to deliver a project successfully.

Assessing Capital

Understanding a subcontractor's financial strength is critical to the prequalification process. It ensures the subcontractor can sustain operations, manage unforeseen challenges, and deliver projects successfully. This evaluation focuses on liquidity, profitability, efficiency, leverage, and backlog.

Obtaining financial statements from subcontractors can be a sensitive process, as these documents are considered highly confidential. Many subcontractors may be hesitant to share this information due to concerns about privacy or misuse. To address this, prequalification managers should:

• Clearly communicate the purpose of the request;
• Identify the specific people who will have access to financials;
• Document the security protocols in place to protect the information; and,
• Offer a mutual non-disclosure agreement (NDA) to build trust.

With financial statements in hand, you can then calculate a series of financial ratios, which provide insight into the subcontractor’s financial viability. Below, we explain each ratio and how to calculate it. We also provide thresholds for moderate and high risk, as well as the Construction Financial Management Association (CFMA) benchmark.

Liquidity

Liquidity measures the subcontractor's ability to meet short-term financial obligations. This ensures the subcontractor can address immediate and unexpected expenses. Four ratios help identify liquidity risks.

Setting Subcontractor Award Limits

A key output of your prequalification assessment is calculating how much business you can safely award to a subcontractor. This requires a limit for each project, as well as an aggregate limit across all projects awarded to the subcontractor. Importantly, limits are mostly science and a bit of art. Financial analysis can calculate an approximate amount, but it’s important to consider qualitative factors, such as experience and capacity considerations, as you finalize limits.

Single Project Limits

Several approaches can be used to calculate single-project limits:

• The Average Three Largest Contracts. By averaging the values of the subcontractor's three largest contracts over the past three years, prequalification managers can gauge the subcontractor's comfort zone. This method is useful for assessing a subcontractor's historical performance with similar-sized projects.
• Surety Underwriter Limit. Surety bond underwriters typically set a single project limit based on their detailed evaluation of the subcontractor's financial and operational capacity. This value provides a reliable benchmark backed by professional underwriting standards.
• Last Fiscal Year Revenue. Using 25% of the subcontractor's annual revenue helps ensure that the awarded project is proportional to the subcontractor's overall financial activity. This approach ensures your project isn’t the sole source of the subcontractor’s viability.
• Cash Balance + Available Line of Credit. This method assesses liquidity and financial flexibility by factoring in cash reserves and credit availability. Multiplying the sum by 3.0 provides a conservative estimate of the subcontractor's capacity to finance a single project.
• Latest Working Capital Multiplied by 3.0. Working capital, a measure of short-term financial health, is a critical factor in determining project capacity. Multiplying this value by 3.0 ensures the subcontractor has adequate resources to manage project demands without financial strain.

By applying one or more of these methods, prequalification managers can establish a contract award limit that aligns with the subcontractor's financial and operational capabilities. One recommended approach is to calculate all the proposed limits and then select the lowest value as the award limit, providing the most conservative risk mitigation. Another method is to take the average of the values. Alternatively, prequalification managers may apply weighting to the lowest three values, take the sum of the weighted values, and use the result to balance conservatism with flexibility.

Setting an Aggregate Contract Limit

Determining a subcontractor's aggregate contract limit – the total value of all contracts that can be awarded – can be accomplished in a few different ways, including:

• Surety Underwriter Aggregate Limit. The subcontractor's aggregate bonding limit, set by their surety bond underwriter, reflects the underwriter's assessment of the subcontractor's financial and operational capacity to handle multiple projects simultaneously.
• Last Fiscal Year Revenue. Using 50% of the subcontractor's annual revenue provides a proportional measure of the total workload they can manage without overextension. This approach ensures the aggregate limit aligns with the subcontractor's financial throughput.
• Cash Balance + Available Line of Credit. This method evaluates the subcontractor's liquidity and financial flexibility. Summing their cash reserves and available credit, then multiplying by 5.0, estimates a maximum sustainable aggregate workload.
• Latest Working Capital. Working capital, a key indicator of short-term financial health, is multiplied by 7.0 to establish a conservative estimate of the subcontractor's aggregate capacity.
• Total Shareholders' Equity. Using four times the subcontractor's total shareholders' equity ensures that the aggregate limit reflects the subcontractor's long-term financial stability and capacity to absorb project-related risks.

Prequalification managers may calculate limits using all of these methods to set an aggregate contract limit and select the lowest value for the most conservative risk mitigation. Alternatively, managers might apply weighting to the lowest three values to create a balanced approach.

The Role of Safety

Safety risks pose significant hazards to workers and anyone in proximity to the project, creating a human cost and jeopardizing the project timeline and budget. A severe safety incident can lead to a work stoppage as investigations are undertaken. Insurance claims and litigation can lead to unprofitable CCIPs and drive up premiums in the future.

Prequalification plays an important role in ensuring your subcontractors have a strong safety culture and put the right measures in place to ensure a safe project. Traditionally, prequalification focused primarily on financial and operational risks but only assessed a few “lagging” safety indicators. These provide a valuable measure of past safety performance, but to truly understand safety risks and take action to mitigate them, GCs must assess leading indicators, such as safety management systems and programs the subcontractor may or may not have in place.

Past Safety Performance

Lagging Indicators are the historical metrics that detail a subcontractor’s safety record. While they are less predictive of future performance than leading and behavioral indicators, they still play a valuable role in risk assessment.

Leading Indicators

Leading indicators are proactive measures that help organizations identify and mitigate potential safety risks before incidents occur. Unlike lagging indicators, which reflect past incidents, leading indicators focus on the presence and effectiveness of safety management systems, program elements, and advanced initiatives.

Safety Management Systems

An effective safety management system provides a structured approach to managing safety, encompassing policies, procedures, and organizational structures aimed at hazard identification and risk control. Key components include employee training programs, management commitment, and continuous improvement processes. You can assess subcontractors' safety management systems by reviewing safety manuals for the presence and sophistication of these systems.

Program Elements

These are specific safety programs targeting particular hazards or activities within an organization. Examples include confined space entry procedures, fall protection plans, and emergency response protocols. You can assess these by asking subcontractors to answer questions related to these program elements, with affirmative responses requiring supporting documentation to verify the existence and adequacy of such programs.

Advanced Initiatives

These initiatives go beyond basic compliance, reflecting an organization's commitment to safety excellence. They may include return-to-work programs for injured employees, substance abuse prevention programs, and participation programs like OSHA's Voluntary Protection Programs (VPP). Evaluate subcontractors on the presence of such advanced initiatives, recognizing their role in fostering a proactive safety culture.

By focusing on these leading indicators, organizations can proactively address potential safety risks, ensuring a safer working environment and reducing the likelihood of incidents.

The Role of Quality

The construction industry recognizes a clear link between a subcontractor’s quality of work and their financial health. Poor-quality work that results in the need to perform rework has clear implications for both safety and financial health. There is also a direct impact on schedule and cost that can stress the subcontractor’s viability.

If a significant amount of rework is required due to poor quality workmanship, acceptance and installation of incorrect materials, installation of damaged materials, etc., the financial impacts can be extremely damaging. In a worst-case scenario, a subcontractor that is teetering can default as a result of the costs that result from poor quality, the need to perform rework, and the subcontractor bearing the brunt of the associated costs to replace their work.

It is estimated that 15-30% of defaults are driven by issues with quality. However, quality-driven defaults are typically much more expensive to remedy. The typical default requires 1.6x the original cost to remediate. But when default is driven by quality issues, it typically costs 2.0x to 2.5x the original cost because of the rework required. Also, rework introduces significant safety risk as poorly installed work must be removed/demolished and replaced often with increased schedule and cost pressure. This exposes labor to safety risks three times over.

Full-Lifecycle Risk Mitigation

Contractor Success Maturity Model

Contractor Success is a bold vision with a strong return on investment, but it’s unrealistic to think a GC can achieve this objective in one fell swoop. Instead, GCs should develop this standard of excellence through a journey we call the contractor success Maturity Model. This journey involves four distinct phases, each building on the previous one and representing increasing sophistication and commitment to full-lifecycle risk mitigation.

Conclusion

Contractor prequalification is not just a procedural step; it is a cornerstone of risk management and project success. By systematically evaluating subcontractors and progressing through the phases outlined of full-lifecycle risk mitigation, general subcontractors can reduce risks, improve project outcomes, and foster collaborative relationships with subcontractors.

This guide underscores the importance of viewing prequalification as an ongoing process. Through continuous monitoring, re-evaluation, and clear communication, general subcontractors can ensure that prequalification evolves into a dynamic tool for mitigating risks and driving improvement. Ultimately, these efforts help build a resilient construction ecosystem where safety, quality, and financial stability are prioritized.

By following this guide, general subcontractors can build stronger subcontractor relationships, enhance project outcomes, and establish a culture of continuous improvement and shared success.