Contract retentions and work in progress

Two numbers, and the price sits inside them

The parent sector page says retentions and work in progress are the whole problem in a contracting purchase, and that a lender will discount both. This page is about how they are actually constructed, what makes them collectable or not, and how to deal with them in the deal rather than discovering them in credit.

Neither is an abstraction. Between them they are frequently the largest current assets on the balance sheet of an electrical or mechanical contractor, and how they are valued moves the price more than anything else in the negotiation.

How a retention comes into existence

Under most standard construction contracts, the customer withholds a stated percentage from each interim payment. That money is released in two stages: part at practical completion, and the remainder at the end of the defects liability period, which can run a year or more after the work finished.

Three features of that mechanism explain why retentions age badly.

The release depends on somebody else acting. The certifier has to certify, the main contractor has to pass it down, and neither has a strong incentive to hurry. A retention is a claim that needs chasing, not an invoice that falls due.

The clock may not start when you think. Where a sub-contract defects period runs from practical completion of the whole project rather than of your own package, finishing early means waiting longer. A package completed in year one of a three-year project can have its final retention sitting unreleased into year five.

There is somebody above you in the chain. If the main contractor holds your retention and becomes insolvent before releasing it, you are an unsecured creditor for money you already earned. That is not a remote scenario in construction and it is the single strongest argument for looking hard at who is holding the money.

Building a retention register that is worth reading

Most sellers can produce a retention total. Fewer can produce the register behind it, and the register is where the value is decided. It needs, per contract: the customer, the main contractor if different, the amount held, the date it was withheld, the contractual trigger for each tranche of release, the expected release date, and whether it has been formally applied for.

Then add the history: what was released over the last three years, how long after the expected date, and how much was written off. That collection record is the only honest basis for valuing what is currently outstanding. Ask for it by customer, because the difference between a public sector client and a main contractor under pressure is enormous and is invisible in a total.

Worked exampleA contractor's balance sheet shows retentions of 400,000. The register shows 260,000 of it is under two years old with release dates within twelve months against customers who have always paid, 90,000 is between two and four years old against one main contractor that disputes several items, and 50,000 relates to projects completed more than four years ago where nobody can now identify the contract. Valuing that at 400,000 is arithmetic. Valuing it at what the collection record supports is diligence. The gap is the negotiation.

Ask, too, whether any retention is held in a project bank account or otherwise ring-fenced rather than sitting in the customer's working capital. Where it is, it is worth more, and the seller will not mention it unless asked.

Work in progress, and the two ways it goes wrong

Work in progress in contracting is not stock. It is cost incurred on uncompleted contracts, plus the profit attributable to the work done so far, less amounts already invoiced. Every one of those three components involves a judgement.

It goes wrong in two directions. The optimistic version recognises the tendered margin on a job that is running over, so the balance sheet carries a profit that will not appear. The pessimistic version, which is rarer and easier to live with, understates work genuinely done.

The tests that expose the first are practical. Take the largest uncompleted contracts and compare cost incurred to date with the tendered cost for the work completed. Ask what has changed in materials and labour since the job was priced. Ask whether variations have been agreed in writing or are being carried in the hope of a settlement at the end. Compare the percentage-complete assessment with the site programme rather than with the finance director's spreadsheet.

A business with a history of finishing jobs at or near tendered margin has earned the benefit of the doubt on its work in progress. One without that history has not, and the difference belongs in the price.

Application, certificate, invoice: three different numbers

Buyers new to contracting frequently treat these as the same thing. They are not, and knowing which is which changes what can be borrowed against them.

An application for payment is what the contractor says it is owed. It is a claim.
A certified valuation or payment notice is what the paying party has agreed. That is much closer to a debt.
An invoice follows, and is the thing a finance provider is most comfortable with.

The statutory payment regime that governs construction contracts turns on notices and timing rather than on the contractor's own view of what it has earned, which is why an uncertified application sitting in the ledger is a weaker asset than it looks. Where a business is carrying a large balance of uncertified applications, find out why. Sometimes it is administration. Sometimes it is a dispute nobody has named yet.

How a lender treats both

Expect a term lender to advance nothing against retentions. They are uncertain in amount and uncertain in date, and no security is available over them in practice.

Expect an invoice finance facility to exclude retentions explicitly, and often to exclude uncertified applications as well. Facilities that will fund against applications exist and are specialist, and they are priced for the risk they are taking. That is precisely the sort of appetite that is not evenly distributed across the market. See invoice finance and working capital.

The consequence for the deal is direct. If the buyer pays book value for retentions and work in progress and the lender advances nothing against them, the buyer has funded that gap from their own resources without intending to. That money then is not available for the working capital swing that contracting produces as it grows. See stacking facilities, because the ranking between the term facility and the working capital line is what makes or breaks this structure.

Pricing them in the deal

There are three workable approaches, and any of them beats paying book value and hoping.

Exclude them. The seller keeps the retentions and collects them, with the buyer agreeing to assist. Clean, and the seller will want to be paid for the administrative burden.
Buy them at a discount derived from the collection history, agreed line by line rather than as a single haircut.
Buy them at book with a true-up. Anything uncollected after a stated period is repaid by the seller, ideally by set-off against deferred consideration rather than as a claim. See deferred consideration and earn-outs.

Whichever route, put the mechanism in the heads of terms. Completion accounts in contracting are where the price genuinely moves, and a mechanism agreed early is far cheaper than one negotiated while everybody is trying to complete. See heads of terms and completion.

What to have ready

Retention register by contract, with ages, triggers and expected release dates.
Three years of retention releases and write-offs, by customer.
Work in progress schedule with the valuation basis stated, contract by contract.
Cost to date against tendered cost on every significant live contract.
Split of the debtor ledger between certified sums and uncertified applications.
A list of live or threatened disputes, however uncomfortable.

Our document checklist covers the rest, and buying an M&E contractor deals with the transaction around all of this.

Why the choice of lender matters most here

A funder with no contracting experience looks at a balance sheet full of retentions and uncertified applications, cannot value it, and declines something that is a perfectly good business. A funder that has lent to contractors before starts from the retention register and the order book and asks the questions above.

This is the sector where that difference is largest, and it is worth saying plainly that the same file will get opposite answers. We know this market and we know specific people who are comfortable with retentions, work in progress and contract risk. Tell us the split between contracting and maintenance, the order book and the retentions position, and we come back to you with who can fund it and what they will want to see.

We introduce buyers who are acquiring through a limited company or a NewCo. If you are buying personally, as a sole trader or as a partnership, we will point you to an authorised firm directly instead.