Advance payments in construction contracts – how they can help with cash flow

Geopolitical unrest and the global pandemic have caused significant supply chain disruption, with a shortage of materials, sharp price hikes and fluctuating supply and demand being just a few issues that can derail construction projects and destroy profit margins.

As these problems are likely to continue to impact the sector for the foreseeable future, there has been an upturn in contractors seeking advance payments from developers to help secure early orders and ensure sufficient cash flow.

Advance payments can benefit both the contractor and the developer. Not only can vital materials be secured as lower prices, they will also be ready for use to ensure projects are delivered on time. However, there are measures that contractors and developers can take to ensure that discussions and contract negotiations run smoothly.

Advance payments – what needs to be considered?

Checks are needed to ensure that any advance payments will be made from available funds, and those are protected should anything go wrong – for both sides.

1. Does the developer have the funds available?

A developer may not have the cash reserves to be able to make an advance payment. If a third party funder is involved then a developer may not be able to obtain the funding until a funding agreement has been drawn up, or a particular set of preconditions has been achieved – which is typically linked to having a signed building contract with the contractor.

Without being able to draw on funding from a third party, the developer is then left with the option of using their own capital to make the advanced payment, before any work has even taken place.

2. Conduct due diligence on a contractor’s financial position

It isn’t just the responsibility of the contractor to check on the developer’s financial position – a developer should also conduct due diligence on the contractor’s position to see if there are any reasons as to why they are asking for an advanced payment. Is it simply just so materials can be obtained at a lower cost before a price hike? Or are there underlying financial concerns with their own cash flow.

Enquiring as to what credit terms a contractor has available with its suppliers is always a reasonable request to make,

3. Ensure you’re protected against any risk of insolvency

Security bonds

To provide some security, developers can ask for a form of bond to protect any advance payment in the event that a contractor goes insolvent, or breaches its contract.

However, this does mean there needs to be discussions around the form of bond, and what the cost of providing that security will be. Given it can impact the contract value, negotiations can sometimes take a while. Therefore it’s essential that both parties consider this option and engage in discussions at the earliest opportunity.

Parent company guarantees

An alternative, and quicker, option could be for the contractor to offer a parent company guarantee as a form of security instead. However, although this option should still provide a robust level of comfort for the developer. If there is an insolvency then this may also affect the parent company – which in turn means the security guarantee is worthless.

Vesting certificates

If materials have been bought in advance and are therefore stored in a warehouse until they’re needed, a developer can ask for a vesting certificate, which will state that the materials belong to the developer and are insured in the event that the contractor becomes insolvent.

Collaboration is key

Having conversations about advance payments early in the tender process is key. As well as having the potential to incur additional administration or legal costs, leaving the discussion until the later stage of the contract negotiations may be seen by the developer as brinkmanship, which could potentially sour negotiations.

By raising the question of advance payments early on, any requests can be checked and agreed by third party funders and advisers in plenty of time.