Small businesses in construction may feel pressured to quickly sign on the dotted line to secure work. But being unfamiliar with certain terms and clauses in contracts can lead to you working on unprofitable jobs or worse — paying out your client when things go wrong.
Celia Jordaan, procurement consultant from Ichiban Commercial Consulting joined us to give her industry insight into the key commercial terms construction industry business owners must be familiar with before tendering for and signing a construction contract.
Firstly, should small business owners always feel they need to sign a contract to get the work?
I see complicated contracts being used in many situations where a purchase order would suffice. With lower value projects (say, under $50,000), I would actually recommend asking prospective clients if a purchase order could be used instead.
If entering into a contract is the only way to get a job, you must read and understand the contract, including the fine print, before signing. If there is anything you don’t understand — seek advice first.
Small business owners often feel pressured to accept contract terms without negotiation because of cash flow issues, but if there are terms or clauses that work against you, you could lose a lot of money.
What are the key phrases to look out for in a contract?
I really want business owners to look out for and understand what these contract phrases mean:
- date for practical completion
- extension of time
- defects liability period
- liquidated damages
The first three I would expect to be included in most construction projects, including smaller ones. The second three terms should be considered with caution, and you should always factor in the additional risks and costs of meeting these clauses, into your price proposal.
Can you explain what these mean, in plain English?
Date for practical completion
This is the date by which the project is agreed to be complete. Most of the items in the project should be done, only really minor items can be finished after practical completion. The latter would typically go on a punch (or snagging) list. When signing a contract ensure the date for practical completion is achievable, and the agreement is written in such a way to protect you from the actions of others that could stop you completing the project on time.
The completion date should be set for a certain number of weeks after site access is granted, rather than a specific date, to ensure you actually have enough time to do the work, even when others may cause delays.
Extension of time
An extension of time is needed if the work will not be completed by agreed date for practical completion. Extensions are generally important when a delay outside your control takes place. Reasons may include changes to the scope by the client, site conditions that weren’t known or disclosed before the project started, adverse weather conditions and lack of access to the site.
Many construction contracts do not allow much flexibility in terms of what is allowed as an extension and you must ask for it within a specific time frame. If you don’t, you may not be allowed to claim at a later date that project completion was delayed beyond your control.
To request an extension, make sure you clearly document and demonstrate why the delays occurred, communicate them to the client as they occur and request an extension of time when you do so. It’s key to have systems in place to document and communicate delays, and manage your project timeframes accordingly.
Liquidated damages are a clause that compels one party to pay compensation to another party for a breach of contract, including not achieving practical completion on time. They are often developed using a formula, such as $5,000 dollars per day, and the payments may be deducted from the contract payment on the client’s say so.
Clearly, this clause can be very damaging to the profitability of a contract for a small business and should be avoided in the first instance if possible, particularly for small value contracts, or reduced to as little as possible.
You must be on the lookout for ‘uncapped’ liquidated damages, which means there is no financial upper limit for the amount of penalty that can be applied. If clients or principals insist on including this clause in a contract, you should negotiate to increase your overall payment to cover your risk, and ensure you limit the liquidated damages that may be claimed to no more than, say, five per cent of your contract price. Remember, if there are any delays outside your control, you should ask for an extension of time.
Defects liability period
This is a set period of time in which any defects that appear in your work or the materials you have used, must be replaced at your own cost. It is typically 12 months, from the date of practical completion. The defect liability period obliges you as a contractor to correct any issues that crop up, as opposed to receiving a financial penalty such as not paying out your retention. It is based on general workmanship and is similar to giving a warranty that the project had been completed in line with the contract.
Security is another way to protect a client or head contractor if you don’t fulfil your obligations in a construction contract. There are different forms of security, but a common one is a bank guarantee. The bank will hold cash from you (or security in the form of a mortgage or similar) and give an undertaking to pay a named beneficiary when a ‘specified event’ occurs. The specified event could be a demand for payment.
You need to understand the situations in which your security could be called on and how much this could affect your finances. Avoid security if possible or negotiate a higher contract payment to protect yourself. Bank guarantees tie up cash flow and if security is required, retention is a preferable form of security.
A retention is a specific form of security that means your client or head contractor withholds part of your contract payment (or progress payment) to ensure you fulfil your contract, or against future defects. This will typically be up to ten per cent of each progress payment, to a total of five per cent of the contract value.
Retention payments will usually be released at agreed milestones. This can be after the completion of the defects liability payment (12 months). Retentions are also to be avoided if possible, as the final payment for your project (which may represent your entire profit margin) is withheld for such a long time.
What are your key tips for small construction business who have been asked to enter into a contract?
- You don’t always need a full-blown construction contract – ask for a purchase order for small value jobs. A purchase order is still a form of agreement but the terms are often simpler and more fit for purpose for small value contracts.
- If you must sign a contract, read it in full — including the fine print!
- If you don’t completely understand what you are getting into, seek advice before you tender and definitely before you sign. Speak to an adviser at the SBDC for free guidance on all business matters.
- Know exactly what your costs might be in the worst case scenario and don’t be tempted to underquote to get the job.
- If your client or head contractor insists on security, retentions or liquidated damages, make sure you calculate the value of these clauses into your quoted price.
Once you have signed a contract there is not much that can be done if you realise the conditions are not in your favour. Don’t be so desperate to secure work that you put yourself in a difficult situation, and learn as much as you can about contracts to protect yourself and your business.
Celia Jordaan is the principal procurement adviser at Ichiban Commercial Solutions, a procurement services advisory firm. Drawing on her expertise in commercial, risk management and procurement, Celia presents workshops on tendering and contracts for us.