THE BOTTOM LINE

Atlantic Coverage Corp.

EXCELLENCE IN SURETY BONDS

3rd Quarter 2003 Volume 5, Issue 3

Retaining Profits in the Business “Famous Quotes” “Man is what he believes.” Anton Chekhov “When a stupid man is doing something he is ashamed of, he always declares that it is his duty.” George Bernard Shaw “Hot heads and cold hearts never solved anything.” Billy Graham “In his private heart no man much respects himself.” Mark Twain “The easiest thing to be in the world is you. The most difficult thing to be is what other people want you to be. Don’t let them put you in that position.” Leo Buscaglia “What one sees depends upon where one sits.” James Schlesinger           It is not uncommon for the stockholders of a company to withdraw the company profits from the business every year. There are good, legitimate reasons for doing this, but it is important that you understand the ramifications of taking a distribution of all the profits, or worst yet, more than the company made in a year.           When applying for credit for the business a creditor will look at many indicators to determine the creditworthiness of a business. The mix of assets, working capital, net worth and revenue are all key indicators of the company’s stability. Another important factor is the company’s growth over a period of three to five years. Trend analysis gives the creditor, be it your bank or your bonding company, a broader picture of the company over a period of time, not just for one year.           We have seen many instances where a company’s revenue increases consistently over a period of years and they’re making money every year. However, the company’s net worth is either stagnant or declining. The reason for the trend in this scenario is usually because there has been a distribution of all of the profits. In a declining net worth situation, the stockholders are withdrawing more than the company made for that year.           As a stockholder you may feel that the company’s profits are yours. You worked hard all year to make money, so why shouldn’t you distribute the profits? This is understandable, but it’s important for the stockholder to step back and look at the big picture. Ask yourself the hard questions. What’s best for my company? Do I plan of staying in business for the long haul? Do I want my business to grow or stay as a small firm?           To help answer these questions, stockholders need to develop a business plan. Not just a plan for the current or up-coming year, but a long-term plan. A well-established business will have a three, five and/or a ten-year business model. These models will take into consideration worst and best case scenarios for their business. Economic outlooks are analyzed and the impact, if any, this would have on their business.           I’m sure when a stockholder or stockholders get together to form a company, it is with plans of growing that business. I don’t think I know of too many people who will put so much effort into starting a business for it just to be a ‘flash in the pan’. A serious businessperson does not have a ‘take the money and run’ mentality.           You may then ask yourself then why take distributions at all? Don’t get me wrong; there are acceptable reasons for taking distributions. Many businesses are established as Sub-chapter S corporations. When a company is set up as a Sub-S Corp. the income is reported on the stockholders personal tax returns and the individual stockholders pay taxes on that income. Taxes are then paid at the lower individual rate instead of at the corporate rate. A distribution of the profits to pay these taxes is perfectly acceptable, if not expected. As a matter of fact, many bonding companies, when analyzing the firms financial statements, will assume that money will be taken from the company for this purpose and take that into consideration in their analysis.           Another common reason for distributions is service debt assumed personally for the benefit of the corporation. One example of this is when the stockholders take out loans personally to pay off a prior stockholder. They then use profit distributions to service and pay off the debt. In this scenario the underwriter may analyze this as a contingent liability of the corporation, especially if the corporation is guaranteeing the repayment of the loan to the lender.           Because distributions are expected with a Sub-chapter S corporation, typically, the underwriter will require personal indemnity. They want to always be able to ‘follow the money’. In regards to personal indemnity, a common question posed is “Well, you have my personal indemnity, what difference does it make if I take out the money?” The answer an underwriter would give you is that they need to see the money in the bonded entity.           There are many other reasons for distributions. The key thing to remember however, is that users of your financial information and grantors of credit will take a dim view of a company that drains the corporation of its earnings just as a matter of course. Be prepared to explain your company’s distribution policy. And if you want your business to grow, it is important to retain the profits in the business.

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THE BOTTOM LINE

“Famous Quotes” “A man who trims himself to suit everybody will soon whittle himself away.” Charles Schwab “The man who insists he is as good as anybody believes he is better.” Ed Howe “Don’t compromise yourself. You are all you’ve got.” Janis Joplin “We always admire the other fellow more after we have tried to do his job.” William Feather “The trouble with most of us is that we would rather be ruined by praise than saved by criticism.” Norman Vincent Peale “People only see what they are prepared to see.” Ralph Waldo Emerson “Character is what you are in the dark.” Dwight L. Moody “The only thing worse than being talked about is not being talked about.” Oscar Wilde Case Study: Sometimes Surety is Right           Through our experiences with Surety Companies we learn lessons that can be used to improve our individual situations. As a Surety agent it is a normal course of business to question the underwriting requirements a Surety may require from an account. After all, what does a Surety underwriter know about being a contractor? Many times both contractor and agent get frustrated with the underwriting process and although we must eventually adhere to the requirements of the Surety, we do so kicking and screaming at first. Yet, if contractors are always right, why is there such a high contractor failure rate? No one plans on failing, yet many do. Conversely, the Bonding companies are not always wrong. What compels the Surety to make decisions that literally affect the business lives of contractors and agents alike?           First, let’s get something perfectly clear. Surety Companies do not make any money by saying NO. The best analogy that can be made would be a contractor turning down an excellent project offered by an owner. However, if the owner wanted the project completed for an unrealistic price, would you take the job? This is what the Surety must decide when considering a new contractor or “stretch” situations with existing clients. For the Surety, it always faces a small upside and a tremendous downside when providing bonds. The average Surety premium is less than 1% of the contract amount. Just because a contractor is successful does not necessarily mean that the contractor is bondable. Similarly, if you already have bonding credit that does not mean you automatically qualify for increased credit, regardless of whether or not you have experienced any problems in the past. You need to sit down with the bond company, just as you would with the owner of that excellent project who expected an unrealistic price, and negotiate what it takes to get everyone on the same page. In this way, all parties concerned are comfortable and know what can be expected from each other.           While contractors are correct that most Surety underwriters do not know the contracting business, underwriters do have many years of historic records that help create “underwriting guidelines”. Surety companies study contractor failures to find out the circumstances leading to these failures. This information is documented and compared with other recorded claims. Patterns for failure are found (such as working out of Geographic territory, cash flow problems, etc.) and underwriting guidelines are established so underwriters can spot these situations before problems result. More recent losses are tracked to see if there is a “current loss trend” in construction taking place. Current trends are primarily what cause Sureties to suddenly change underwriting guidelines. With years of the soft market behind them, a current loss trend is for contractors to have too much backlog on hand and not enough cash flow to support the backlog. As you may have noticed, the underwriting trend of today is that contractor’s working capital be stronger for the line of credit being requested. The following case study is a recent (and brief) example of what Sureties are facing today.           A general contractor that had been in business for over a decade started looking to grow his firm. Part of his reasoning was that he could not compete with the smaller contractors on projects under one million dollars anymore. This was happening even with his low overhead, and up to this time he was demonstrating success on projects of this size. This contractor had been bonded for many years with the same bond company and the Surety was willing to support the growth as long as a minimum working capital and net worth were maintained. The first large bond was provided with no issues and everyone was happy. One year had passed and the contractor was looking to fill up his backlog. He was nearing completion of that large project and had a few other smaller projects substantially complete. A new financial statement was issued and it looked to support the contractor’s needs. However, the accounts receivable looked to be slow and under-billings were quickly adding up. The bond company asked for details regarding the receivables and under-billings and the contractor agreed that he had been having problems collecting money on his projects of late. Initially the bond company attributed the increased under-billings to change orders and assumed that they were collectible. They also noted that there were four projects in progress and all substantially were underway, if not close to completion. All projects seemed slow in receivables collection. The contractor, however, needed to bid some work to fill up his backlog again. Having been associated with the contractor for a number of years, the Surety agreed to provide some additional bonding, but on smaller projects. This was decided so as not to risk the contractor’s cash flow. However, the contractor continued to insist that he needed larger projects to be competitive. The Surety understood this situation. They asked the contractor how he planned on addressing his cash flow situation when he began mobilizing new projects, since he was not capable of collecting the money owed to him on the projects nearing completion. The Surety pointed out how this could become a cash flow drain to the contractor. In the meantime, the Surety was receiving some initial payment claims from vendors that the contractor owed substantial sums of money to, on numerous projects that were in progress.           Meanwhile, the contractor was low bidder on 2 fairly sizable projects he bid. Now the Surety was forced to check on the status of the projects in progress. The references received by the Surety

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THE BOTTOM LINE

“Famous Quotes” “He who knows others is clever; he who knows himself is enlightened.” Lao-tzu “It’s good to have money and the things money can buy, but it’s good, too, to check up once in a while and make sure that you haven’t lost the things that money can’t buy.” George Horace Lormier “We are what we pretend to be, so we must be careful what we pretend to be.” Kurt Vonnegut, Jr. “It is impossible for a man to be cheated by anyone but himself.” Ralph Waldo Emerson “When you are right, you cannot be too radical; when you are wrong, you cannot be too conservative.” Martin Luther King, Jr. “After I am dead I would rather have men ask why Cato has no monument than why he had one.” Cato the Elder stated that the contractor’s work was good, but paperwork on projects was poor. The contractor was told by the Surety company that he should concentrate on collecting his money and not to go after any additional work. This annoyed the contractor, who continued to insist he needed more work.           The contractor asked the agent to place him with another bond company. After consulting with the contractor’s accountant the agent felt comfortable that the receivables were good and eventually collectible and decided to move the account. The old Surety wrote one of the low bids and the new Surety wrote the second low bid (this was a bid that the first surety approved but would not write the final bond due to its decision that cash flow was a problem). However, after these bonds were issued it became evident that the contractor was indeed having collection problems. At this point the agent discussed with the contractor that he should really concentrate on collecting his money and handling his existing backlog. If he were to take on more contracts he would be putting his company in jeopardy by severely straining cash flow, having too many projects to start up at one time, and having no money coming in from the projects nearing completion. It had also become evident to the agent that the contractor was counting on this cash coming in to support start up of his new work. His bank line was maxed out by now and there was no additional personal cash that could be loaned to the business. The contractor obviously did not agree with his agent and found a new bond company, which supported him on some sizable bids. The agent strongly suggested he not take on any additional work when he was told that he was going to a new bond company. The contractor was low on two bids and was provided the Performance and Payment bonds from this new bond company. This bond company was the third that the contractor was with in less than three months.           Here are the unfortunate results. The contractor is now out of business. His choices are to work for someone else or try starting another business. He is still responsible for his debt to the Sureties. All three bond companies have claims issues regarding his account. The original Surety and the second Surety have potential losses, but they seem to be limited. The third Surety company, which wrote the last two bonds, has more potential exposure on hand. It is important to note that all through this situation (which took place over a course of eight months) the contractor’s financial statements technically supported the backlog this contractor was requesting. If the last Surety company that underwrote this contractor allowed the accounts receivable showing up on contractor’s last statement as current, the underwriting ratios actually came close to supporting the final bonds issued at the end. The last Surety actually did this contractor much more harm than good by writing these last two bonds.           Here is a case where the contractor would probably be in business today if he had listened to his original Surety company. The Surety company had seen situations like this before and explained its concerns to the contractor. Now hindsight is twenty-twenty, however, the contractor did not consider the surety’s advice at all. He believed the Surety was being too restrictive and that they were causing his problems. Remember, Sureties make NO money by saying “no”. They do benefit by long-term relationships and a steady flow of income from their contractor clients. Perhaps the biggest difference between contractors and the Sureties is that contractors tend to look at their short-term needs while sureties consider the long-term ramifications of their decisions. It’s very easy to see how this case came about. Contractors need backlog to stay in business, while sureties need to avoid claims to stay in business. It would not be a bad policy for contractors to sit with their Sureties when considering larger growth, geographic expansion, etc. The Surety will not have the answers, but it will provide solid examples and valuable information that will allow you to make a well-informed decision.           Today contractors will benefit by communicating more with their Surety. Not only do they provide you with valuable Surety bonds, but they also have a wealth of knowledge and experience that can aid in your success. The Surety may not know how to build that bridge or building, but they do know how you can avoid the pitfalls that can lead to your failure on such projects. They want to see you succeed almost as much as you do. The Code of Hammurabi – Think Things are Tough Now?           If you thought that being a contractor in today’s market was stressful, think about being one in 2500BC. The following was taken from Hammurabi’s Code of Laws as translated by L.W. King and the Eleventh Edition of the Encyclopedia Britannica. There were 282 such laws. We have only included the ones that pertained to building.           #229. If a builder builds a house for someone, and does not construct it properly, and the house which he built falls in and kills its owner, then that builder shall be put to death.           #230. If it kills the son of the owner, the son of that builder shall be put to death.           #231. If it kills a slave of the owner, then he shall pay slave for slave to the owner of the house.           #232. If it ruins goods, he shall make compensation for all that has been ruined, and inasmuch as he did not construct properly this house which he built and it fell, he shall re-erect the house from his own means.           #233. If a builder builds a house for someone, even though he has not yet completed it; if then the walls seem toppling, the builder must make the wall solid from his own means.

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